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Full text of "Cases in accounting policy"

UNIVERSITY 
OF FLORIDA 
LIBRARIES 




- 






Digitized by the Internet Archive 
in 2013 



http://archive.org/details/casesinaccountinOOharl 



Cases in 

ACCOUNTING 

POLICY 



Cases in 

ACCOUNTING 
POLICY 



NEIL E. HARLAN 

Associate Professor 

Graduate School of Business Administration 

Harvard University 



RICHARD F. VANCIL 

Assistant Professor 

Graduate School of Business Administration 

Harvard University 



PRENTICE-HALL, INC 
Englewood Cliffs, N.J. 1961 



© 1961 by PRENTICE-HALL, INC., Englewood Cliffs, N.J. 
All rights reserved. No part of this book may be reproduced in 
any form, by mimeograph or any other means, without permis- 
sion in writing from the publishers. Library of Congress Catalog 
Card No.: 61-14393. 

Printed in the United States of America 

11866- C 



Preface 



This collection of cases is designed specifically for 
use with an accounting text at the intermediate or 
advanced level. Probably not more than half of the cases would be suitable 
for a first accounting course: except perhaps for one tailored specifically 
to the needs of non-accounting students, in which the importance of an 
understanding of the principles of accounting and the bookkeeping cycle 
might be less than that for students concentrating in accounting. Our 
primary concern in this book is with the needs of the student of account- 
ing, often referred to as "the accounting major," a classification to which 
both of the authors, at one time or another, have belonged. In fact it is 
from our own experiences, first as accounting majors and later as account- 
ing teachers, that we have formed the conviction that the prudent and 
competent use of cases can add a dimension of realism and vitality that 
is too often missing in accounting education. 

Moreover, this is not sl book in management accounting within the mean- 
ing of that term as generally used to refer to the collection, interpreta- 
tion, and presentation of data for internal operating decisions in the busi- 
ness enterprise. In a broader sense, however, the decisions which have 
to be made in the cases in this book are management decisions. They deal 
with the vital management function of reporting to the owners, the finan- 
cial community, regulatory agencies, and the general public on the results 
of the operations of the business enterprise. This function has become 
no less important during recent years, simply because the quantitative 
aspects of internal decision-making have begun to receive their due con- 
sideration. 



vi Preface 

Except where specifically indicated, all the cases in this book were 
developed for use in courses at the Harvard Graduate Business School, 
and are copyrighted by the President and Fellows of Harvard College. Al- 
though over two-thirds of the cases are "field" cases— that is, they are based 
on field research within the actual companies involved— we can thank 
publicly only those companies which have elected to have their cases ap- 
pear in undisguised form. These companies are: Textron, Inc.; Trans 
World Airlines; Jordan Marsh Company; The Reece Corporation; The 
Boston Patriots; and the Harvard Law Review. To list the remaining firms 
which cooperated in the writing of these cases would, of course, be in- 
consistent with their preference to remain anonymous; we are nonetheless 
grateful for their contributions. 

Case collection is a slow and difficult process demanding the time and 
effort of many individuals. Robert H. Deming, Robert C. Hill, and L. Paul 
Berman, as staff members at the Harvard Business School, have had a 
large share in the writing of these cases. Professors Ross G. Walker, 
Robert N. Anthony, Charles A. Bliss, Walter Frese, and Russell H. Hassler 
have also contributed to this book. Three cases come from members of 
other institutions: Professor Wiley Mitchell of the University of Kansas, 
Professor DeWitt Dearborn of the Carnegie Institute of Technology, and 
Doctor Russell Bowers of DePaul University. Each has permitted us to 
use a case developed by him and copyrighted by his institution. Professor 
Earl D. Bennett, formerly of the Harvard Business School and now at the 
University of Texas, has permitted us to use two cases from his book Cost 
Administration, also published by Prentice-Hall. The best source of ideas 
for improving cases is actual experience with them in the classroom; our 
teaching colleagues, Professors Charles Christenson, John Dearden, 
Robert Jaedicke, and John Yeager, have contributed generously in this 
respect. And, as is always the case, enormous secretarial effort has gone 
into the production of a finished manuscript. We single out our secretaries, 
Miss Helen Kosakowski and Miss Mary Fustolo, to represent the con- 
siderable number who have contributed in this respect. 

We express our appreciation to all these individuals without implying 
any responsibility on their part for the structure and quality of this book. 

N.E.H. 
R.F.V. 



Table 

of Contents 



Part I— Preparation and Analysis of Financial Statements 



Preparation of Financial Statements— Review 

Introduction 1 

1. Masters Fuel Oil Company 9 

2. Angus Cleaners 16 

3. Oliver Optics Company 20 

4. Foley Circle Garage 23 

5. Morehohse Container Company 27 

6. H. William Kraft 33 

7. Berkshire Country Club 40 

8. Pearsons Department Stores, Inc. 40 



Analysis of Financial Statements 

9. Brother-in-Law 60 

10. Ibbard Chemical Products Corporation 65 

11. Cole Appliance Stores, Inc. 70 

12. Jensen Publishing House 75 

13. Industrial Uniforms, Inc. 79 

14. Beldon Woolen Company (A) 91 

15. Beldon Woolen Company ( B ) 97 

vii 



viii Table of Contents 

Part II — Formulation of Accounting Policy 

A. Policy Formulation for Specific Types of Transactions 

Recognition of Revenue 

16. Trumpet Magazine 103 

17. Industrial Factors, Inc. 110 

18. Charles Crowne Company 120 

19. Golden Stores, Inc. 133 

Inventory Valuation— Determination of Cost of Goods Sold 

20. R. H. Shay Motor Company, Inc. 140 

21. Showdown at Sunset Pass 146 

22. Jordan Marsh Company (A) 151 

23. Wade Processors, Inc. 161 

24. Pahala Sugar Plantation, Ltd. 166 

25. Rocky Mountain Construction Company 176 

26. Amos Carholtz Distillery, Inc. 188 

27. Beale Company 199 

28. The Bayard Nail Company 206 

Assets: Valuation and Amortization 

29. Waters & Son, Inc. 227 

30. Shipstead Electronics Corporation 236 

31. The Pan American Company 241 

32. International Trading and Investment Corporation 245 

33. Miller Salt Company 256 

34. Textron Inc. (A) 273 

35. Textron Inc. (B) 286 

36. The Reece Corporation 291 

Deferred Expenses 

37. Textron Inc. (C) 295 

38. Textron Inc. (D) 299 

39. Trans World Adelines 302 

40. Francono Cosmetics Company 310 



Table of Contents ix 

Liabilities and Reserves 

41. Textron Inc. (E) 317 

42. Textron Inc. (F) 323 

43. Continental Minerals Company 326 

44. Russey Electrical Service Company 330 

B. Multi-Policy Formulation for the Business Enterprise 



45. The Boston Patriots 334 

46. Adamian Metallurgical Corporation 351 

47. Microflex, Inc. 363 

48. Bill French, Accountant 382 

49. Redwood Memorial Park 389 

50. Harvard Law Review 408 



Topical Index 429 



Introduction 



D 



uring the years 1955 to 1959, Trans World Air- 
lines spent $17 million in "jet integration" costs 
—costs incurred in getting ready to fly jet aircraft. Pilots had to be trained 
or retrained; crews had to be familiarized with the unique problems of jet 
aircraft maintenance; new supporting equipment was needed; and ad- 
vertising funds were required to acquaint the public with the new trans- 
port service represented by jet air travel. All these expenditures flowed 
naturally from the decision of TWA's management to make the transi- 
tion from conventional propeller-driven aircraft to the high-speed trans- 
port planes of the jet age. 

Following this sequence of decisions which, in their total effect, com- 
mitted TWA's stockholders to an expenditure of $17 million, the Com- 
pany's executives were faced with one more management decision: 
how the $17 million expenditure would be related to the airline's earn- 
ings as reported to stockholders. This latter decision was as truly a man- 
agement decision as those which had caused the expenditures in the first 
place. We shall refer to such decisions as accounting policy decisions. In 
the TWA case, the decision either had to be made within the framework 
of an accounting policy already explicitly or implicitly established, or a 
new policy had to be especially formulated to deal with this apparently 
unique accounting problem. 

Over what period of time should "jet integration" costs be amortized? 
It is difficult to argue, in principle, with the Civil Aeronautics Board's 
answer to this question ( essentially, that costs should be matched against 
revenues ) . Stated in such general terms, however, both the question and 
the answer are purely academic; in any practical sense the question, as 
stated, is unanswerable. Perhaps it should be possible to invoke some 
"accepted accounting principle" so unequivocal in its formulation and 
so precise in its application that nothing would be left to the decisional 
whims of management— that as a matter of principle the answer would 
be inevitable. That such is not the case is apparent from the fact that 
among the major airlines, all of whom have faced this same problem, 
the amortization periods employed have ranged from two to ten years. 
All these treatments have been accepted by highly reputable firms of 



2 Introduction 

Certified Public Accountants and all of them have met the requirements 
of the Civil Aeronautics Board. Management is neither protected nor 
hindered by a prescribed and uniformly accepted treatment. A man- 
agement decision must be made; and for the case at hand it must be 
made, not in some theoretical, doctrinaire sense, but specifically for 
Trans World Airlines. 

The problem just described is illustrative of the accounting policy 
questions included in this book. These cases present a wide range of 
situations which require a decision on the part of management— a deci- 
sion that can be made rationally only within the framework of care- 
fully determined accounting policies. And although the ultimate respon- 
sibility for such a decision rests with management, a primary role in the 
formulation of the underlying accounting policy is assumed by the com- 
pany's chief accounting officer or by its independent public accountants. 
It is in this role as management's professional advisor on matters of ac- 
counting policy that perhaps most of the students using this book will 
wish to place themselves. The collection of cases has been planned espe- 
cially with this audience in mind. 

We believe, however, that whether the student sees himself as a po- 
tential advisor to management or, sooner or later, as an active participant 
in management, he should constantly try to identify himself with specific 
problems in their specific settings as he studies the cases. The case method 
of study, in addition to being an effective means of developing a real 
understanding of substantive knowledge and helping the student to cul- 
tivate his ability to develop and express his own original thoughts, is 
also a proven method of approximating, in the classroom, long and varied 
experience in the business world. 



CASE PREPARATION AND CLASSROOM PARTICIPATION 

A successful experience in case study requires a great amount of stu- 
dent effort. Case discussions are exciting and productive only if the 
members of the class are well prepared and individually willing to ex- 
press and defend ideas which they think are worth while. The case 
method leans heavily on the individual. But we know from our own 
experience that the student welcomes the opportunity to become an 
active part of the process of education. He also responds to the idea that 
his thoughts are worth something, too. In the long run, of course, it is 
his thought and effort .that will determine his success in the real world. 

Although the student is properly on his own in the classroom, he should 
not necessarily restrict his prior study to individual effort. It is some- 
times useful if the student, after becoming completely familiar with the 
case facts and arriving at his independent judgment as to the critical 
issues in the case, can then participate in a small (five-to-eight-student) 
group discussion for a few minutes, perhaps half an hour, before going 



Introduction 3 

to class. Such discussions should not try to treat the case in detail. Rather, 
they should permit each group member to get a quick group reaction 
to his approach and compare his approach to others. It may give him a 
better understanding of the strengths and weaknesses of his position. 
The brief group discussion can also frequently save the student from 
the embarrassment of suddenly realizing, in the presence of the entire 
class, that he has overlooked an important case fact that lays his whole 
approach open to question. 

As valuable as the small group discussion can be, it should not be 
allowed to become a crutch for the individual. The group should not go 
into class with a "group decision"; in fact the small group will frequently 
not be able to reach a unanimous opinion. The student should contribute 
to, and take from, his group discussion the ideas which he thinks are good 
and then, when he enters the classroom, be himself and depend upon 
himself. He should be willing to present his ideas and defend them as long 
as he is convinced of their value; this he is usually anxious to do. Perhaps 
the sterner test comes in developing the ability to accept another's idea or 
plan when one recognizes it as being superior to his own, even when the 
student may feel a temporary "loss of face." To do this requires a high 
degree of emotional maturity and intellectual courage. 

If the members of the class can, while pursuing their separate lines 
of thought, move toward a solution, or perhaps more than one, which 
the class generally accepts as being sound and reasonable, the sense of 
accomplishment will be great. This will also undoubtedly be the instruc- 
tor's objective. He will often find it difficult to refrain from taking an 
active role in the discussion. The student is naturally anxious to know 
what the instructor thinks about the issue under discussion, perhaps be- 
cause the student would like to know the "right" answer, but sometimes 
simply because he is anxious to know whether the instructor agrees with 
him. The student should be prepared to have the instructor enter into 
the discussion at his own discretion, for he will be concerned with the 
pedagogical aspects inherent in the use of cases. The line between facili- 
tating learning and interfering with it is a delicate one. Guarding that 
line on the side of learning is the instructor's prerogative as well as his 
responsibility. 



BEWARE THE RIGHT ANSWER 

The student should not always expect to have the answer carefully 
tucked away in his notebook when he leaves the classroom. It is entirely 
possible for two equally competent students to arrive at quite different 
conclusions from the same set of "facts" in the same situation. A wide 
range of opinion may be defensible in both theory and practice. If this 
is true for students, it is of course also true for the instructor. The in- 
structor will not always have the right answer. Usually, of course, he 



4 Introduction 

can be expected to have considered the question under discussion care- 
fully enough to be aware of the reasonable alternatives and to have 
arrived at his own judgment as to the treatments that are preferable. 
But the class should not expect that the instructor's views will always 
be expressed at some time during the class. 

We hope the preceding comments have not been interpreted to indi- 
cate that virtually any case solution is acceptable. Clearly, for a particu- 
lar problem there may be many suggested treatments which will not 
stand up under careful examination. The class can be expected to dis- 
pose promptly of off-the-cuff recommendations framed from superficial 
study of the case. It is only after the patently unacceptable treatments 
have been eliminated and a list of practicable approaches has been de- 
veloped, that the selection process becomes difficult and the opportunity 
for real learning great. Although the individual student may, at a rea- 
sonably early stage in the decision, make his own choice from among 
the treatments that are worth consideration, he has not taken full ad- 
vantage of the learning opportunity until he understands why another 
member of the class has reached a different opinion. 



CASE COVERAGE 

In putting together this collection of cases, we have made an effort to 
cover a wide range of industries. In addition to many cases involving 
manufacturing and retail distribution, this book includes cases about the 
following kinds of companies: book and magazine publishers, a movie 
producer, a sugar plantation, an industrial park land developer, a com- 
mercial factoring house, a cemetery, a whiskey distiller, and a profes- 
sional football team. The purpose behind this diversity is more than to 
provide the spice of variety: since the basic principles of accounting are 
applicable to all types of commercial enterprises, these cases offer an 
opportunity to apply familiar principles to situations which the student 
may not have thought about before in an accounting context. Textbook 
"solutions" are not available here, and the student will have to do some 
original thinking to develop a set of accounting policies really appro- 
priate for such businesses. 

We have also attempted, where pertinent, to include in the cases an 
explanation of the permissible income tax treatment of certain types of 
transactions. Income taxes have had an important effect (too important, 
we believe) on the selection of accounting policies for financial report- 
ing purposes. In some of the cases in this book, the student will have 
an opportunity to evaluate this interrelationship for himself, and will 
be forced to resolve the question of producing for tax authorities "profit" 
figures that are different from those disseminated to other users of finan- 
cial statements. 



Introduction 5 

We believe that the study of these accounting policy matters within 
the natural context in which they arise will enable the student to develop 
his technical knowledge and skill into an effective part of the vital process 
of business management— as the accounting member of the management 
team or as a public accountant providing independent professional con- 
sultation. 



PART 



Preparation and Analysis 
of Financial Statements 



PREPARATION OF FINANCIAL 
STATEMENTS-REVIEW 



CASE 1 



Masters 

Fuel Oil Company 







n the morning of January 14, 1959, Mr. Leonard 
Masters appeared at the office of his accountant, 
Wallace Stone. Masters was troubled, and explained his concern to Stone 
in the following words: "When you started handling my account last 
May, you said that my books seemed to be in pretty good shape. Since 
then weve been doing about the same volume of business as last year— 
maybe a little more, but not very much. IVe been thinking about the 
informal reports you've been giving me on how we're doing, and from 
what you say it looks like we've doubled last year's profit. I can't see 
how that can be right. Don't you think we ought to check this out before 
you make up our 1958 reports?" 

Mr. Masters, with his son-in-law, Louis Webster, operated Masters 
Fuel Oil Company. The principal activity of this company was delivery 
of heating fuel to residential customers; it had been registered as a part- 
nership on July 1, 1956, after having been operated as a sole proprietor- 
ship by Leonard Masters for seventeen years. The company was operated 
from the Masters home. Mrs. Masters and her daughter kept the records 
of deliveries ( sales ) , receipts, and disbursements; Mrs. Masters billed all 
customers monthly. In addition to these members of the family, the com- 



10 Masters Fuel Oil Company 

pany had recently taken on one full-time and two part-time workers to 
handle residential service work and to operate the company's second 
truck, acquired December 1, 1958. Louis' younger brother was frequently 
paid out of petty cash for performing such tasks as washing the trucks or 
answering the telephone. 

Prior to the formation of the partnership and the hiring of driver- 
servicemen, the needs of the firm for formal records and accounting 
information were limited largely to billing and tax requirements. The 
changes, however, brought about a need for determining the partners' 
share of profits and for reporting payroll information to state and federal 
offices. Louis Webster was also somewhat more businesslike than his 
father-in-law and pressed for more formal handling of the company's 
records. For these reasons, Masters and Webster decided that they would 
no longer depend on a "friend of the family" to figure their annual profit 
and income tax. Wallace Stone was contacted and was engaged to review 
the records of transactions monthly, to post to a set of accounts in a gen- 
eral ledger, to prepare quarterly statements and payroll reports, and to 
prepare the annual tax returns. 

When Mr. Stone first visited the Masters home, he was given the in- 
come statement and balance sheet for the company's last full business 
year, which ended December 31, 1957 (see Exhibits 1 and 2). He dis- 
cussed the operations of the firm at some length with the principals and 
was reasonably well satisfied that the affairs of the company were fairly 
presented in the statements. 

On the basis of his initial interview, and his monthly visits, Stone ob- 
served the general manner in which the records were maintained. Briefly 
stated, his observations follow: 

Cash Receipts: A record of all receipts, entered chronologically by the 
name of the payer, was maintained by Mrs. Masters. 

Cash Disbursements: A record of all checks issued was maintained by 
Mrs. Webster. She reconciled the cash balance each month with the bank 
statement and noted any errors or discrepancies. 

Cash Records: The receipts and disbursements journals (above) were 
completely transcribed, totaled, and balanced each month prior to Mr. 
Stone's visit. 

Payroll Records: A record of hours worked by each employee was 
maintained by Louis Webster. This record was the basis for issuance of 
payroll checks and preparation of payroll reports. 

Sales: Although customers were billed monthly on the basis of metered 
delivery tickets, no entry in the sales accounts was made to reflect either 
the delivery or the billing. Instead, all cash receipts were recorded as 
sales when Mrs. Masters entered them in the cash receipts journal. She 
also prepared a list of accounts receivable on December 31 of each year; 



Masters Fuel Oil Company 11 

this list was used as the basis for year-end adjustment of the sales and 
receivables accounts. 

Budget Accounts: Approximately half of the annual gallonage was sold 
to customers participating in the company's Budget Account Plan. Each 
of these customers made equal monthly payments for nine months of the 
year (September through May) and in June balanced the account. If 
the customer's account showed a credit balance in June, he could choose 
either to receive a refund check at that time, or to apply the credit against 
the next following payment. 

Budget Plan customers paid neither a service charge nor a carrying 
charge. They were required, however, to purchase an annual service con- 
tract for which a $25 charge was the initial entry against their account. 
The contract covered cleaning and inspection of heating apparatus once 
during the year, usually in the July or August preceding the budget 
period, and expired each year at the end of the budget period. It also 
guaranteed free service and parts according to terms and conditions 
specified in the agreement. 

Mr. Masters' experience proved that it was virtually impossible to tell 
when he would have to provide repair service. The dollar cost had not 
varied greatly, however, for several years. Cleaning service, on the other 
hand, was much simpler to plan for; it involved a fixed commitment 
which could be scheduled conveniently and discharged under predictable 
conditions of cost and time. 

Mr. Masters was particularly enthusiastic about the cleaning portion 
of the service contracts. Except for incidental costs of replacing filters, 
labor time was his only real cost. Masters maintained that the cleaning 
work done under the Budget Plan Service Contract was at least as good 
as the work billed to noncontract customers. These customers were 
charged $15 for cleaning and inspection. Although relatively few non- 
contract accounts called for cleaning service, Masters denied that his 
rate was established to induce customers to enroll in the Budget Group. 
Competing firms offered similar cleaning services for $10 to $12. 

The foregoing is a reasonably complete summation of Wallace Stone's 
knowledge of the Masters company up to the time of Mr. Masters' visit 
to his office. He did, of course, have a complete file of data on the 1958 
operations (see Exhibit 3) and was about to prepare the annual state- 
ments for the partners. Now that Masters had questioned the profit fig- 
ures, Stone felt obliged to take a little more time before releasing any 
statements. 

Stone discussed the matter briefly with Masters and then agreed to 
meet with him and the other members of the family the following eve- 
ning at Masters' home. At the meeting, attention soon centered on the 
marked difference in accounts receivable at the end of the two years in 



12 Masters Fuel Oil Company 

question. Mrs. Masters recalled, then, that there was some problem in 
setting up the balance of receivables at the end of last year. The friend 
who had been helping with the books had completed preparation of the 
tax returns before Mrs. Masters had totaled all the accounts. Explaining 
to Stone, Mrs. Masters said, "He had only the tape on the budget ac- 
counts. 1 When I called him and told him that I had the tape on all the 
other accounts, he said that he'd already finished the work and that it 
would all balance out." Mrs. Masters searched her desk and found the 
listing of accounts receivable that had not been recorded on December 
31, 1957. The adding machine tape showed a total of $14,377.18. 

Required 

1. Using the data that Stone had prior to Masters' visit on January 14, pre- 
pare the income statement and balance sheet for Masters Fuel Oil Co. 

2. How shall Mr. Stone explain the situation to the Masters and Websters? 
Will it "all balance out"? Why? 

3. What accounts, if any, were misstated on December 31, 1957? on Decem- 
ber 31, 1958? 

4. What corrections, if any, would you make in the two sets of statements? 

5. What are your recommendations for the handling of the record of cus- 
tomers' accounts in the future? 

6. How should Stone reflect Masters' year-end liability on service contracts? 



1 Under the system used by this company, receipts on budget accounts had been 
recorded as budget plan income when received. The excess of delivery values over 
budget receipts had not been formally recorded. It was these amounts that Mrs. 
Masters calculated so that they could be added to budget plan income for the year. 



EXHIBIT 1 



Balance Sheet, December 31, 1957 



ASSETS 

Cash in bank $13,993 

Accounts receivable 12,486 

Inventory of parts 5,490 

Deposits on commercial bids 900 

Total current assets . . ". $32,869 

Furniture and fixtures $ 1,481 

Less: Depreciation allowance 566 $ 915 

Delivery and service equipment $23,786 

Less: Depreciation allowance 9,787 13,999 

Building $21,699 

Less: Depreciation allowance 7,364 14,335 

Land 6,000 

Total long life assets 35,249 

TOTAL ASSETS $68,118 



LIABILITIES AND CAPITAL 

Accounts payable $ 4,382 

Other liabilities 256 

Total liabilities $ 4,638 

Leonard Masters, Capital, January 1 $28,970 

Less: Drawings for the year 10,364 

$18,606 

Add: Half share of profit for year 12,689 

Leonard Masters, Capital, December 31 $31,295 

Louis Webster, Capital, January 1 $29,860 

Less: Drawings for the year 10,365 

$19,495 

Add: Half share of profit for year 12,690 

Louis Webster, Capital, December 31 32,185 

TOTAL LIABILITIES AND CAPITAL $68,118 



13 



EXHIBIT 2 



Income Statement 
for the Year Ended December 31. 1957 



Income from Sales and Services: 

Fuel oil, nonbudget accounts , $ 97,587 

Budget plan income 80,895 

Burner service and repairs 14,876 

Installations 10,980 

Total Income $204,338 

Cost of Sales and Services: 

Fuel oil delivered $143,367 

Burner parts and supplies 3,877 

Installation costs 5,219 

Subcontractor charges 1,472 

Total Cost of Sales $153,935 

GROSS PROFIT ON SALES $ 50,403 

Operating Expenses: 

Depreciation expense $ 5,602 

Wages 6,751 

Vehicle expense 2,496 

Telephone 219 

Advertising 3,423 

Office and printing 1,019 

Utilities 437 

Taxes (other than payroll) 912 

Professional fees 1,480 

Payroll taxes 335 

Uniform rental expense 386 

Supplies 198 

Miscellaneous expense 1,766 

Total Operating Expense $ 25,024 

NET PROFIT FROM OPERATIONS . $ 25,379 



14 



EXHIBIT 3 



Operating Data, 1958 



Cash Receipts Journal : 

Received from regular customers $106,478 

Received from budget plan customers 97,798 

Received for burner service and repairs 12,714 

Received for installation work 4,460 

Received deposit refunds 750 

Total Receipts $222,200 

Cash Payments Journal : 

Paid 1957 accounts payable $ 4,382 

Withdrawn by L. Masters 12,650 

Withdrawn by L. Webster 15,000 

Paid for fuel purchases 146,260 

Paid for burner parts 5,905 

Paid for installations 2,111 

Paid to subcontractors 314 

Paid for utilities 424 

Paid for supplies 277 

Paid for new truck 12,133 

Paid for telephone 231 

Paid for advertising 2,627 

Paid property taxes 972 

Paid office and printing costs 1,119 

Paid fees for professional services 1,520 

Paid 1957 other liabilities 256 

Paid payroll taxes (1958) 212 

Paid for rental of uniforms 512 

Paid for vehicle operation 2,312 

Paid wages* 9,816 

Paid miscellaneous expenses 1,949 

Total Disbursements $220,982 

Additional Information : 

Accounts Payable, 12/31/58 

For fuel oil purchases $ 3,962 

For utility bills 36 

For burner parts 438 

For advertising 159 

Other Liabilities, 12/31/58 

Employers payroll taxes unpaid 278 

Accounts Receivable, 12/31/58 

Regular accounts $18,640 

Budget accounts 12,172 

Depreciation for 1958. 

Furniture and fixtures— straight- line at 10% of asset cost. 
Delivery and service equipment— straight- line at 20% of asset cost. 
Building— Straight- line at 5% of asset cost. 

Inventory of burner parts, 12/31/58 $ 8,250 

*Witholding taxes not to be considered. 



15 



CASE 2 



Angus 
Cleaners 



D 



uring November 1952, Mr. Roy Angus left his job 
as a spotter ! in a dry-cleaning plant and set 
about the task of establishing a dry-cleaning business of his own. Mr. 
Angus had accumulated approximately $9,000 in his savings account by 
virtue of the settlement of his father's estate and by saving a portion of 
his own weekly wage for several years. Anticipating the forthcoming need 
for business expenditures, Mr. Angus withdrew $8,000 from his savings 
account and deposited the money in a special checking account to be 
used for business purposes. 

Mr. Angus had already selected a business site in a rapidly growing 
suburban shopping area. The premises provided ample space to conduct 
both the dry-cleaning operations and certain retailing functions. In his ar- 
rangements with the lessor, Mr. Angus agreed to a rent of $125 per 
month payable on or before the first of the month to which the rental 
would apply. The lease agreement was in the form of a one-year lease 
with an option to renew indefinitely. In closing the arrangement on De- 
cember 12, Mr. Angus paid $250 rent in cash for the months of January 
and February, 1953. He anticipated operations would commence in Jan- 
uary, 1953. 2 

1 A job involving the removal of spots from clothing. 

2 The lessor agreed to give Mr. Angus access to the premises rent-free before 
January 1, 1953. 

16 



Angus Cleaners 17 

Late in December 1952, Mr. Angus purchased equipment for the dry- 
cleaning operations and furniture and fixtures at a cost of $9,780. 3 To 
conserve funds, Mr. Angus made a down payment of $4,280 to the whole- 
saler who furnished both the equipment and furniture and fixtures and 
signed a noninterest-bearing note for the balance of $5,500. The note 
called for equal monthly payments of $275 to be made over a 20-month 
period. The first installment on the note was to be paid prior to January 
31, 1953, and subsequent payments were to be made before the end of 
ensuing months. All this equipment was ready for use when the business 
opened. The wholesaler stated that the equipment and the furniture and 
fixtures were ordinarily replaced after 15 years and had no salvage value. 

In the latter part of December, Mr. Angus purchased 24 plastic gar- 
ment bags to be resold to customers who wanted a moth-and-dirt-free 
storage container. These garment bags were purchased for cash by Mr. 
Angus for the retail list price of $90 (retail list price per bag was $3.75) 
less a trade discount of 33% per cent. In addition to the garment bags, 
Mr. Angus purchased, on account, supplies costing $34. 4 Mr. Angus 
checked the balance in the company checking account and found that 
it was $3,410 on December 31, 1952. 

Opening day, January 2, was a busy one for Mr. Angus. He arranged 
for taking in clothes to be dry-cleaned, and he assigned his help, whom 
he had arranged for in December, to their respective jobs. 

In January, Mr. Angus received bills for the freight ( $147 ) and instal- 
lation ( $603 ) of the dry-cleaning equipment he had bought in December. 
Mr. Angus promptly paid in cash the $750 total of these bills. 

Because of the large amount of work taken in during January, Mr. 
Angus believed his business was successful enough to warrant making 
some additional expenditures. First, in order to increase his sales further, 
and to offer his customers additional service, Mr. Angus purchased a used 
delivery truck at the beginning of February. This truck, already three 
years old, was purchased by Mr. Angus for $1,400, of which $800 was 
paid in cash, and a $600, 6 per cent per annum interest-bearing note, 
due August 1, 1953, was given for the balance. Mr. Angus asked the 
former owner about his method of depreciation. The former owner stated 
that his depreciation was based on an estimated five-year useful life for 
the truck. The truck had originally been purchased for $3,100, and a 
depreciation allowance of $1,860 had been accumulated for the three- 
year period it was owned. Mr. Angus figured the truck would have four 
additional years of useful life and a salvage value of $200 at the end of 
that period. 

3 Equipment included dry-cleaning machines, presses, boiler, spotting board, irons, 
wet-cleaning equipment, tables, tubs, and bleach jars. The furniture and fixtures in- 
cluded storage racks, a sales counter, and signs. 

4 Supplies include solvent, soaps, bags, hangers, spotting and marking supplies. 



18 Angus Cleaners 

The second large expenditure Mr. Angus made was for the installation 
of a partition between the front sales office and the dry-cleaning plant 
in the back. This partition, which was to include storage closets, was to 
replace a curtain which had been in use from the time the business 
opened. During February, this partition was constructed at a cost of 
$330, which Mr. Angus paid in cash. Mr. Angus worked out an agreement 
with his landlord whereby Mr. Angus was to receive the use of the 
premises rent-free for March and April in return for incurring the cost 
of the partition. Under the terms of the lease agreement, the partition 
became the property of the landlord. 

On April 1, Mr. Angus took out a three-year fire and theft insurance 
policy. The total cost of the three-year policy was $240, which was paid 
in cash. 

At the end of June, Mr. Angus was anxious to find out how his busi- 
ness had fared over the first six months of operation and to determine his 
present financial position. From his records of cash and charge sales for 
the first six months, he derived the following information: 

Total cash dry-cleaning sales $ 9,460 

Total cash garment bag sales (84 bags at $3.75/bag) .... 315 

Total dry-cleaning charge sales collected 5 3,175 

Total dry-cleaning charge sales outstanding June 30/53 .... 453 

$13,403 



Included in the cash dry-cleaning sales were receipts for work done 
on clothes which were later returned because they were physically dam- 
aged. Mr. Angus was successful in all instances in getting customers to 
accept the value of their claims in the form of credit which they could 
apply against their subsequent dry-cleaning bills. The total amount of 
credit extended for these claims was $55. On June 30, the amount of 
credit on claims given to customers that had been taken advantage of 
by the customers was $48. When the credit allowed customers on claims 
was used by the customers for subsequent dry-cleaning services, the 
amount of the credit used was not considered as a sale by Mr. Angus 
and therefore was not included in the sales figures given above. In addi- 
tion, customers returned clothes for which they paid $30 to have dry 
cleaned, and Mr. Angus recleaned these clothes without charge. 

From the stubs in his checkbook and from a file of bills paid out of 
the cash drawer, Mr. Angus listed as follows all the cash expenditures 
made between January 1 and June 30, 1953, with the exception of the 
cash expenditures mentioned previously for: freight and installation of 
equipment; truck; partition; and fire and theft insurance: 



5 These are not included as part of cash sales. 



Angus Cleaners 19 

Accounts payable outstanding January 1 $ 34 

Payments to employees (does not include drawings by 

Mr. Angus) 5,312 

Heat, light, and power 610 

Advertising 182 

Gas and oil for truck 212 

Rent (for May, June, and July) 375 

Payments on equipment 1,650 

Supplies (soap, solvents, etc.) 1,806 

Garment bags ($3.75 list price less 33%% discount) . . 250 

Miscellaneous, general, and administrative expense ... 68 
Premiums on Mr. Angus' personal automobile insurance 

(the automobile was not used in the business) 140 

Mr. Angus' drawings 1,500 

$12,139 



The cash expenditures for rent mentioned above included the rental 
fee for July, which was paid on June 29. Mr. Angus also noted that 
another $86 of labor expense had been incurred but was unpaid as of 
the end of June. His June heat, light, and power bills amounting to $115 
had not been paid at the end of the month. 

The only other unpaid bill on June 30 was for supplies; it amounted to 
$163. Mr. Angus took an inventory of supplies on hand and calculated 
their original cost as $94. 

Thirty-eight garment bags were on hand June 30 which had cost Mr. 
Angus the retail list price of $142.50 less a trade discount of 33% per cent. 
Mr. Angus had taken two garment bags home for his own use during 
May. These bags cost Mr. Angus $2.50 each and had a retail price of 
$3.75 each. 

Included in the charge sales outstanding at the end of June was a 
$12 unpaid account of a customer who had moved out of town; Mr. 
Angus believed he would never receive payment. He estimated that an 
additional $5 of the $453 of accounts receivable outstanding on June 30 
would probably be uncollectible. Mr. Angus felt that the amount of un- 
collectible accounts in the following six months would be the same as in 
the past six months. 

Required 



1. Prepare a balance sheet as of January 1, 1953, an income statement for the 
six months' period ending June 30, 1953, and a balance sheet as of June 
30, 1953. 



CASE 3 



Oliver 

Optics Company 



w 



hen John Oliver graduated from technical 
school, he immediately started a small business 
making special lenses and certain high-quality optical items for the scien- 
tific and military demand. At the time, there was keen demand for a high- 
quality product, and Oliver thought he could build a substantial business 
by stressing this quality element. After a year of some very disturbing 
and revealing difficulties in meeting customers' high standards, Oliver 
thought he had things going well. By working hard and personally satisfy- 
ing all complaints, he knew he had created much goodwill for his firm. 

Oliver had started his business with $5,000 of savings, including some 
money he had inherited. At the end of the third month, he borrowed 
$2,000 on a one-year note, 4 per cent, from his uncle, who had intimated 
he would renew the note every year as long as Oliver needed the money. 
He had had large bills for materials, but had been able to keep from 
falling too far behind in his payments. Except for the accounts indicated 
below as unpaid, all bills had been paid in cash. 

Mr. Oliver purchased some standard equipment at the first of the year 
"on time," agreeing to make a partial payment of $1,000 and to pay $250 
every three months for four years. Since the payments were scheduled 
to start at once and since he had agreed to pay $60 interest every six 
months in advance, his initial payment was $1,310. A year having passed, 
the fifth payment of $250 would now have to be met, plus $60 interest.. 

20 



Oliver Optics Company 21 

When the equipment was bought, the company insisted on Oliver's 
taking out four years' insurance, which cost a total of $200. The equip- 
ment presumably would be useful for at least 10 years, though Oliver 
contemplated that if all went according to his plans, he would have to 
get rid of the equipment in five years and buy some with a greater 
operating capacity. 

By the end of the first year, Oliver had three people working for him. 
One was a young lady who took care of his office work and spent about 
one-third of her time packing the delicate products as they were com- 
pleted in the shop. The other two workers, hired at about the third 
month, spent all their time in the shop. About 20 per cent of Mr. Oliver's 
time was spent in office work and on selling trips, but the rest of the 
time he was to be found in the shop working with the other men. 

At the end of the year, Oliver's records included the following: 

Salaries paid (through December 31) 

Miss Schultz $ 1,200 

John Bardell 3,200 

Peter Nutchell 3,500 

John Oliver 6,000 

Rent 2,000 

Unpaid bills from suppliers * 5,130 

Paid bills from suppliers 12,120 

Uncollected accounts 

U. S. Government 5,150 

Universities Scientific Supply Company 4,130 

Payment due Oliver for subcontract work, completed, and shipped, 

December 17— Pegasus Aircraft Company 970 

Spent on office supplies 250 

Inventory on hand, at estimated cost 

Raw materials and supplies 830 

Goods in process 1,270 

Finished goods 1,100 

Office supplies 50 

Various administrative and selling expenses (including travel and 

advertising) 2,730 

Electricity, etc 430 

Cash on hand ** 730 

Most of Oliver's sales were to two buyers, the U. S. Government and 
the Universities Scientific Supply Company. Oliver had sold some $310 
worth of goods to one buyer earlier in the year when business was slow, 



* Does not include the balance due for the equipment referred to in the third 
paragraph of the case. 

** Does not include a check for $2,030 from Universities Scientific Supply Com- 
pany, believed to be in the mail as their regular settlement of accounts as of the 
close of the previous month. Charges for the last month were $2,100 additional. 



22 Oliver Optics Company 

and when the man became bankrupt with no assets whatever and with- 
out having paid his bill, Oliver promised himself, "Never again." Other 
firms, he was told, protected themselves against such losses by use of a 
charge of 1 per cent of year-end accounts receivable as an allowance 
for bad debts. 

In October, the Pegasus Aircraft Company had asked Oliver to do 
some work for them, altering special equipment which they sent on to 
Oliver's shop. The first lot had been completed before the year's end, 
but the payment for the work, $970, had not been received. A second 
shipment, apparently valued at $3,000, had just come in (afternoon of 
December 31) from the Pegasus plant, but the alteration work (which 
would come to about $1,000) had not yet been started. Mr. Oliver as- 
certained that the value of this incoming material, $3,000, had not been 
included in the totals for inventory listed above. 

Approximately $800 of the finished goods inventory consisted of 200 
special items that had been made for a government order, but had not 
as yet been shipped. Frankly, Mr. Oliver had wanted the situation to 
settle a little before making delivery, for a previous shipment of the 
same size (one-half the original order) had not met the specifications 
of the government inspectors, and Oliver had been notified that 20 per 
cent of the shipment was being returned as unsatisfactory. Fortunately, 
the items carried a 30 per cent markup over Oliver's cost, so he would 
not fare too badly. Still, Oliver was disturbed about the matter because 
he thought his inspection standards, when the first batch had been made, 
had been no different from those in force at any other time, and besides, 
he was advertising high-quality products. He certainly had no idea as 
to why the 20 per cent had been rejected. He intended to file an appeal 
to try to collect the full amount that he had billed the government (in- 
cluded in the $5,150 in the year-end listing given above), particularly 
since the rejected items could not be reworked and were not worth much 
to any other possible buyer. 



Required 

Work out Mr. Oliver's operating statement for the year and his ending 
balance sheet. You should show clearly how any figure not taken directly 
from the text has been determined. (The figure on sales has been omitted 
deliberately for the purposes of this problem, and must be found indirectly 
from the relationships of the accounts.) 



CASE 4 



Foley 

Circle Garage 



i 



n the fall of 1954, John Flynn and George O'Brien 
purchased the Foley Circle Garage from L. K. John- 
son, its former owner, and proceeded to operate it. The following facts 
concern the purchase of the property and the operation of the business 
for the six-month period, September 1, 1954, to March 1, 1955. 

The two partners paid $90,000 for the business, $65,000 of which was 
obtained on a 4 per cent mortgage note from the local bank to be amor- 
tized by annual payments over 10 years. Each partner put in $20,000, 
Mr. Flynn getting a loan of that sum from a relative at a nominal inter- 
est rate of 2 per cent and Mr. O'Brien borrowing $10,000 from his bank 
at 4 per cent on a personal note and selling $10,000 worth of 3 per cent 
bonds which he had inherited from a recently deceased uncle. Thus the 
balance of $25,000 on the purchase price was paid, and $15,000 was 
made available for current cash needs. 

The balance sheet for the garage as worked out by the former owner 
at the time of the sale was as shown in Exhibit 1. 

Under the terms of the purchase, the former owner, Mr. Johnson, 
agreed to settle all liabilities of the company and to turn over all assets 
other than cash and accounts receivable to the new partners. They ex- 
pected to take over the former owner's dealership of a popular low- 
priced car, which if granted to them by the manufacturer (note: it was) 
would be worth, in their words, "at least $25,000 a year." The garage 

23 



24 Foley Circle Garage 

alone, valued at $50,000 (after depreciation) on the former owner's 
books, was expected to last 20 more years— at least so an experienced 
appraiser told the partners when they were considering the purchase. 
Mr. Johnson, the former owner, told them that according to his books 
there would be only 10 more years of depreciation charges of $5,000 a 
year. The equipment (net, $15,000) was, on the average, one-half de- 
preciated, and the appraiser thought a five-year remaining life appro- 
priate. 

At the end of the six months' operation, the new partners had the 
following records: 

Sales 

Gasoline, oil, etc $ 23,150 

Repairs, parts, etc 41,000 

New cars (cost $58,000) 74,300 

Used cars (trade-in value $18,400) * 21,200 

$159,650 

Costs 

Gasoline, parts, and supplies (total to date) $ 21,450 

Interest (paid through 2/28/55) 1,300 

Wages, salaries, and commissions (including $19,000 selling 

and administration) 40,100 

Insurance (a three-year policy purchased September 1) .... 600 

Advertising 1,500 

Miscellaneous payments (cash) 2,140 

$ 67,090 

Accounts payable, gasoline, and supplies $ 950 

Gasoline, parts, and supplies on hand 2,300 

New cars on hand 8,100 

Used cars on hand 11,900 

New equipment ( 10-year expected life, bought January 1 ) .... 12,000 

Cash on hand, February 28 6,080 

At the end of the six-month period (February 28), there were me- 
chanics' wages accrued and unpaid of $400. In addition, there was a 
memorandum that $200 included in the wages and salaries item of 
$42,100 had been an advance to one of the salesmen whose wife had 
been rushed to the hospital for an emergency operation. 

As of February 28, accounts receivable were $1,750 for everything but 
car sales, and the partners thought a bad debt reserve equal to 4 per 
cent of outstanding receivables was about right. 

Customer accounts for car purchases were not large because most 
customer financing, where necessary, was handled by banks and finance 
agencies. The partners had made some loans, however, and as of the 
end of February the amount outstanding was $6,500. Interest totaling 



* At the time of the turn-in of the used cars, the Foley Garage had allowed $18,400 
on the purchase of new cars. 



Foley Circle Garage 25 

$220 had been collected on these notes, but $700 principal plus $75 in- 
terest was in arrears and unpaid ( as of February 28 ) . 

The partners had been careful but liberal in offering trade-ins on sales 
of new cars. Nonetheless, they were afraid that in view of certain adverse 
circumstances there probably was a 10 per cent overage (that is, $1,190) 
in the figure for used car inventory at the end of the period, and they 
wanted the accounts adjusted. The records showed that $300 worth of 
parts and $200 of labor had been spent fixing up the used cars now in 
stock, and $400 more of parts and $700 of labor in fixing up cars that 
had been sold. 



Required 

1. Work out beginning and closing balance sheets and an operating state- 
ment for the intervening six-month period. 



EXHIBIT 1 



Balance Sheet, August 31, 1954 



Assets 
Current assets: 

Cash $ 4,900 

Accounts receivable .... 7,100 
Inventory of supplies, 

gasoline, etc 3,600 

New cars, at cost 13,100 

Used cars, at trade-in 

value 900 



Liabilities and Proprietorship 
Current liabilities: 

Accounts payable $ 8,300 

Accruals 470 

Total $ 8,770 

Other liabilities 

Mortgage 24,400 



Total $29,600 L. K. Johnson, owner 61,430 

$94,600 



Fixed assets 

Garage and equipment 
(after depreciation) 



65,000 
$94,600 



26 



CASE 5 



Morehouse 
Container Company 



A* 



rthur L. Morehouse was the operator of a mod- 
erately successful box and crate manufacturing 
company. The business had been started in 1947 when Morehouse, un- 
employed, applied for a job at a local aircraft plant. Unable to secure 
employment, Morehouse left the plant and took a short cut home through 
the company dump. As he was walking, Morehouse noticed that a truck 
crew was dumping and piling a load of damaged, but obviously re- 
pairable, wooden crates. On inquiring, Morehouse was told that the 
crates would, as usual, be burned. 

By the time he reached home, Morehouse had decided that the crates 
stacked up in the dump could be turned into a profit. In rapid order, 
he obtained permission from the aircraft company to remove (free of 
charge) all damaged crates from the dump, to repair and recondition 
the crates, and to resell them (at negotiated prices) to the company. 1 

On the strength of the verbal commitments from the purchasing agent 
of the aircraft firm, Morehouse withdrew $350 from his fast-dwindling 
savings account and purchased a used truck. On the advice of a friend, 
he purchased a parcel of land about a mile from the aircraft plant. The 
land, which was acquired for $915 in back taxes, was occupied by a 



1 Morehouse had to agree to continue to cart away all crates that were taken to 
the dump; failure to satisfy this requirement would cause him to lose his privilege. 

27 



28 Morehouse Container Company 

weather-beaten, barn-type structure which, although it had no apparent 
market value, was suitable for a shop or garage operation. Thus, although 
Arthur Morehouse was unable to secure employment with the aircraft 
manufacturer, his visit to that firm led to the establishment of the More- 
house Container Company. 

By the end of 1957 the container company had grown in size, and 
was considered to be one of the outstanding examples of personal suc- 
cess in the community. The Morehouse company employed fourteen full- 
time and four part-time workers; it manufactured crates, packing boxes, 
structural forms, and many types of wooden shipping containers; and 
it supplied the needs of a large number of firms in the local area. Al- 
though the aircraft manufacturer was still Morehouse's primary customer, 
the "dump-clearing" arrangement had, by 1957, long since been ter- 
minated. Morehouse's lumber needs had grown to the point where it was 
necessary for him to purchase board lumber directly through agents 
dealing in New England and Canadian timber. 

Early in 1958, Morehouse was considering several opportunities for 
expanding his business. He felt that bank-borrowing was generally bet- 
ter suited for his purposes than attempting to secure additional invested 
capital involving admission of a partner into the business; accordingly 
he contacted John Thurman, loan officer at his business bank, for in- 
formation. At Thurman's request, Morehouse forwarded his tabulation 
of income and expense for 1957 and his balance sheet for the end of 
that year (see Exhibits 1 and 2 for these statements as they were pre- 
pared by Morehouse). 

Within a few days, Thurman called and suggested that he and More- 
house meet to discuss matters in more detail. At the bank the next day, 
Thurman explained that his primary purpose was to make sure that the 
loan committee received the most useful information that was available. 

The two men spent several hours discussing the operation of the busi- 
ness and the methods by which Morehouse kept his records; Thurman 
expressed satisfaction with the meeting and, after securing from More- 
house a folder of papers which contained information in support of the 
statements, promised that he would contact Morehouse shortly. On the 
basis of the statements, the papers in the folder, and his meeting with 
Morehouse, John Thurman accumulated the information that follows: 

Land and Buildings: As was previously mentioned, the land and orig- 
inal buildings were acquired in 1947 for payment of back property 
taxes. Arthur Morehouse was well aware that his payment was an ex- 
tremely poor reflection of the real value of the property. For that reason, 
he had carried the property on his records, from the time that he acquired 
it, at a conservative appraised value. In 1950, to reflect a general in- 
crease in property values in the vicinity, Morehouse decided to adjust 



Morehouse Container Company 29 

his books. He discussed the value of the property with a local realtor, 
and then revised his balance sheet to show the property valued at $12,000. 

In 1951, Morehouse received a bid of $4,800 for construction of a row 
of concrete sheds in which to store lumber so that it would be protected 
from the weather. Prior to approving a contract for the work, he was 
able to acquire a substantial portion of the necessary materials at ex- 
traordinary savings. As a result of his acquisition of building materials 
that cost him $950, Morehouse secured a reduction of the bid amount 
to $2,800. He nevertheless carried the improvement in his records at the 
original bid figure. Unquestionably, he maintained, the lesser total cost 2 
did not fairly reflect the real value of the addition under normal con- 
ditions. 

Factory Equipment: The principal pieces of equipment in the factory 
were the power saw and the nailing machine. Both pieces of equipment 
were purchased new in 1949, and had an expected useful life of 15 years. 
(Morehouse traded in some useless pieces of machinery when he pur- 
chased the two new units. The pieces traded in were found in the build- 
ing when he took possession, were valued at $600 for trade-in credit, and 
resulted in a net cash outlay of $8,360 at the time of purchase. More- 
house figured that the machinery which he traded in would have been 
worth about $250 if he had tried to sell it.) 

Morehouse considered such things as small hand tools to be temporary 
in nature and, thus, an immediate item of expense. He estimated that 
he had $350 worth of small hand tools in the shop at the end of 1957; 
all had been bought before 1957. 

Delivery Equipment: In addition to the truck that he purchased in 
1947, Morehouse operated another vehicle that he purchased new in 
1954. The old truck had, of course, been fully depreciated and no longer 
showed in the records. In March, Morehouse paid $2,680 to have the 
old truck completely reconditioned. The cost of reconditioning was in- 
cluded in the amount that Morehouse figured for delivery expense for 
1957. In Morehouse's estimation, the reconditioning work was the sole 
factor that would make it possible for him to use the truck for another 
three or four years. 

Bad Debts: The debt loss experience of the company had been next 
to nothing for several years. Morehouse understood, however, that the 
tax law allowed him a bad debt deduction each year and, accordingly, 
he charged a flat $125 annually as expense. In 1957 his only loss was 
$66; this amount was due from a small local concern that was legally 
adjudged bankrupt. As the $125 deduction was the greater amount, 
Morehouse had charged this as an expense. Consequently, he had not 
removed the $66 from his accounts receivable. 



2 The total cost to Morehouse was $3,750; that is, the bid amount of $2,800 was 
paid to the contractor; in addition, Morehouse provided the materials worth $950. 



30 Morehouse Container Company 

Depreciation: Morehouse figured depreciation on his property at the 
following rates: 

Years 

Land and buildings 30 

Machinery and equipment 10 

Trucks 5 

The year of acquisition was treated as a full year in computing deprecia- 
tion expense. 

Other Information: The inventory figure for December 31, 1957, in- 
cluded $1,980 which was the agreed purchase price, plus freight, of an 
order of Canadian pine due for delivery in early January. Morehouse 
usually received notice approximately a week before the shipment would 
reach his yard; he would take title on delivery and would pay the shipper 
at that time. 

In addition to selling boxes and crates outright, Morehouse had de- 
veloped a sideline in a box-rental service. Although the gains from his 
rental service were not significant, Morehouse was interested in the 
possibility of further developing that type of business. Essentially, More- 
house constructed a packing or storage box in one standard size at a 
cost of approximately $15.40. Then, he rented the boxes to local moving 
and storage companies at a charge of one dollar a month plus an initial 
five-dollar deposit. At the end of 1957, there were about 300 of the 
boxes out in use and 100 in the storage sheds. As best he could tell, 
Morehouse figured that the boxes would last anywhere from one to five 
years, depending upon the type of use to which they were put. As a 
rule of thumb, he allowed an average of two years as the normal life of 
a rental packing box. Experience indicated, also, that about 20 per cent 
of the boxes that were rented out were never returned. Normally, More- 
house would receive rental on these boxes for a year, more or less, and 
then the user would discontinue making rental payments. (Very rarely 
did any of these users request that their deposits be returned. ) Whenever 
a box was returned (regardless of condition), Morehouse was obliged 
to return the deposit. Morehouse made no distinction between the rental 
receipts and the deposits, but rather took both into income as they were 
received. 



Required 

As analyst for the bank's loan officer, prepare an income statement for 1957, 
and a year-end balance sheet. Prepare these statements in a form that you 
feel will be helpful to the bank's loan committee in evaluating the finan- 
cial position of the Morehouse Container Company. If you find it necessary 
to choose between different methods of handling various items, briefly ex- 
plain your choice. [Note: Because of the complications involved in the cal- 
culation of individuals' income taxes, you may ignore all tax considerations.] 



EXHIBIT 1 Record of Income and Expenses 

1957 

Income : 

Sales of boxes, crates, etc $137,910 

Sale of lumber scraps 480 

Rental of packing boxes 3,260 

Deposits on packing boxes 850 

Miscellaneous income 116 

$142,616 

Expenses : 

Wages to employees $ 52,680 

Wages to Arthur Morehouse 10,200 

Supplies used 3,880 

Truck repairs— regular 320 

Machinery repairs 620 

Loss from bad accounts . 125 

Delivery expense 11,095 

Depreciation expense 3,896 

Utilities and operating 1,736 

Real estate and property taxes 768 

Installment on truck note (1957 installment) 900 

$ 86,220 

Use of Inventory : 

Last year's inventory $ 9,876 

Purchase payments in 1957 31,420 

$41,296 

This year's inventory 6,640 $ 34,656 

Total costs $120,876 

Profit $ 21,740 



Note : In addition to his wages, Morehouse drew a total of $8,400 in 1957 
against profits. 



31 



EXHIBIT 2 



Balance Sheet, December 31, 1957 



Assets 



$11 



Cash in checking account . 

Petty cash at office 

Accounts receivable— good . . 8 
Accounts receivable- 
disputed* 

Accounts receivable— badf . • 

Lumber inventory 6 

Miscellaneous supplies .... 

Boxes on consignment! .... 1 

Inventory of rental boxes . . . 1 

Total pO 

Machinery 8 

Truck 12 

Land and building 12 

Storage sheds 4 

Total $68 



383 
162 
,740 

482 

66 

,640 

320 
,296 
,540 



,629 
,960 
,200 
,000 
,800 



,589 



Liabilities 

Owed to suppliers $ 846 

Wages not picked up 22 

Note on truck (due in 1958). . 900 
Charged off for bad accounts 

to date 500 



Total $ 2,268 



Depreciation— Machinery ... $ 8,064 

Depreciation— Truck 9,760 

Depreciation— Land and 

building 4,400 

Depreciation— storage sheds. 1,120 



Total $25,612 



Owner's Interest 



Total assets $68,589 

Total liabilities and depreciation . . 25,612 

Difference, being owner's 

net interest at 12/31/1957 . . . $42,977 



♦Amount in dispute on a September 1956 shipment to aircraft plant. More- 
house cannot locate receipted delivery ticket, and customer has no record of re- 
ceiving the shipment. No word on the matter in last six months; last word was 
that payment could not be made without proof of delivery. 

fDue from firm declared bankrupt on May 16, 1957. 

$A local lumber supply house carried six dozen packing boxes on a "subject 
to sale" (or consignment) basis. They pay for boxes only as boxes are sold and 
retain a 10 per cent commission for their services. The boxes were similar to 
rental boxes, cost about the same to manufacture, and were priced to sell for 
$20. 



32 



CASE 6 



H. William 
Kraft 



o 



n April 27, 1958, Mr. H. William Kraft became 
the owner of business property in Moundsville 
and Herculaneum, Vermont, that had been bequeathed to him by a 
lifelong friend and business associate. Kraft, 68 years old and the operator 
of a highly successful lumber and building supply firm in near-by Perry- 
ville, viewed the real estate operation with mixed feelings. On the one 
hand, his supply business required his full attention, and he could not 
afford to spend very much time on other matters; on the other hand, 
Kraft understood that the properties had been moderately profitable in 
the past, and he wished to take full advantage of the income that they 
could produce (see Exhibit 1 for description of properties, tenants, and 
conditions of tenancy). 

Kraft received the properties subject to all rights and claims that at- 
tached to them or to his deceased friend's business as owner and operator 
of the properties. The terms of the will made this quite clear. He was 
required to accept responsibility for all liens against the properties; he 
also had a right to all benefits that accrued to the properties in any 
way. Since the estate taxes had been paid out of the general assets of the 
estate, Kraft was advised that he should not expect any assessment for 
estate taxes. This was in accordance with his friend's wishes. 

Partly because he did not wish to become involved in the details of 
rent collection and partly because he wanted to give one of his younger 

33 



34 H. William Kraft 

employees a chance to broaden his experience, Kraft assigned William 
Roland to the job of managing the properties. Roland was an assistant 
to the bookkeeper of Kraft's lumber firm, and had impressed Kraft and 
other members of the firm as being diligent and intelligent. Roland was 
told that his "primary job on the rental property will be to keep a record 
of the rent checks as they come in" and to keep Mr. Kraft informed of 
any major developments. 

As it turned out, the rental property required much more from Roland 
than the processing of monthly rent checks. Roland, a $60-a-week clerk, 
soon became the manager of a small but time-consuming rental business 
that demanded most, if not all, of his working time. In addition to matters 
of such routine nature as receiving and processing rent checks, many 
other tasks confronted him daily. Tenant complaints, building repairs, 
payment of bills, visits to the property, and a variety of small matters 
that the tenants wished to discuss with him consumed virtually all his 
time. Roland learned that the former owner had operated his properties 
on a very friendly, family-like basis; and Roland, largely because the 
tenants were accustomed to personalized treatment, found it very dif- 
ficult to reduce the amount of time that he was spending in Moundsville 
and Herculaneum. 

At the end of 1958, Mr. Kraft felt that it would be well to draw to- 
gether the results of the year's operations. (By December 31, he had 
hired another assistant bookkeeper for the lumber business and, starting 
September 1, had raised Roland's pay to $75 a week.) Roland collected 
all the information that he had on the properties, and then Mr. Kraft 
instructed him to put together an income statement and balance sheet. 
The following is a summary of the data that William Roland had to 
work from: 

Value of the Property: For estate tax purposes, the Moundsville prop- 
erty had been appraised at $450,000 and the Herculaneum property at 
$375,000. The assessed valuation for property tax purposes was con- 
siderably less than this amount, Moundsville being taxed on a base of 
$240,000 and Herculaneum on $200,000. Kraft had been offered, shortly 
after taking title to the properties, $380,000 for Moundsville. As recently 
as November, he had been offered $400,000 for the Herculaneum parcel. 
Kraft knew that the original owner had purchased both parcels together 
for $270,000 in 1938. Kraft estimated that the buildings would be in good, 
usable condition for at least another 30 years. Although he was not cer- 
tain, he believed that the amount of the original purchase price attribut- 
able to the land was something in the vicinity of $100,000. 

Rental Collections: Rental receipts for the year amounted to $22,975. 
Roland found, during the year, that $1,040 of that amount was for rental 
payments that were due but not paid prior to April 27. On December 31, 



H. William Kraft 35 

$1,005 in rentals was due but not received. ( See Exhibit 2 for Roland's 
record of rent receipts. ) 

Repairs to Buildings: During the year several situations arose that 
required repairs to the buildings. Roland listed the repairs and classified 
them as follows: 

Normal operating repairs: 

Moundsville $ 440 

Herculaneum 280 

Replacement of hot water boiler at Herculaneum property 
(guaranteed for five years, but should be good for at 

least ten) (installed June 28) 550 

Redecoration of office for new tenant at Herculaneum (com- 
pleted late August) 125 

Repair of fire damage at Moundsville property (Hosiery 

Shop) 18,500 

Value of materials used from regular business 1 

Moundsville— normal repairs 1,210 

Moundsville— fire repairs 3,650 

Herculaneum— normal repairs 640 

Operating Expenses: In addition to items that he classified as repairs, 
Roland also noted the following normal operating costs: 

Cleaning and janitorial costs: 

Moundsville $ 350 

Herculaneum 280 

Fuel and electricity 

Moundsville 2,180 

Herculaneum 3,200 

Water rents 

Herculaneum 172 

Advertising: As noted in Exhibit 2, an office in Herculaneum was 
vacated in June. At that time, Kraft authorized Roland to enter into an 
agreement which amounted to a three-year contract for advertising with 
a local newspaper. For a payment of $600, Kraft would be allowed up 
to 100 lines of classified advertising a month for thirty-six months. Since 
there were a number of lease expirations coming due in the next two 
years, Kraft thought it wise to take advantage of what could be a sub- 
stantially lower advertising rate than normal for the area. Also, since 
there was no restriction on the subject matter in the advertisements, he 
felt that the lumber business could always make use of the contract. The 
agreement was dated June 3, and the only use of the advertising space 
in 1958 was to list the office vacancy in Herculaneum. Full lineage was 
used in June and July, and forty lines in August. 

Tenant Security Deposits: Although there was no cash transmitted 
with the property, Roland found that several of the tenants had paid 
security deposits when they first took occupancy. Because the informa- 



1 No payment as such was made to the lumber business for these. The figure 
given does not include Kraft's standard 25 per cent selling markup. 



36 H. William Kraft 

tion that was originally turned over to Kraft was, at best, very sketchy, 
there was little to do but credit the various tenants with deposits in the 
amounts that they claimed. As best as he could determine, the amount 
of deposits to be recognized was $1,030 ( see Exhibit 1 ) . 

Water Rentals at Moundsville: One of the tenants at Moundsville had 
complained most vehemently that he was paying the water bill for all 
the upstairs tenants. When a plumber checked the situation in late May, 
he reported to Roland that the tenant was correct. All water consumed 
on the upper floor was being charged through the beauty shop meter 
and the beautician, Phil Mancuso, was actually paying the water bill for 
several other tenants. For $260, the plumber installed separate lines and 
meters and solved all but the problem of compensating the beautician 
for past payments. 

Kraft's offer of $150 met with favorable response, but no formal settle- 
ment had taken place by December 31. Kraft had not decided whether 
to make a direct disbursement or to apply the amount of the settlement 
against future rents. Neither had he decided whether he should attempt 
to charge the other tenants for their share of the adjustment. 

Fire Damage: In September, a fire damaged the Moundsville property, 
and it was necessary to expend considerable time and money in repairing 
the premises. The fire was confined largely to the hosiery shop and did 
little damage to other parts of the building. Between September and the 
end of the year, by which time the repairs were completed and the prop- 
erty almost completely restored to its original condition, Kraft spent 
$18,500 for the various costs of repairing the damage. Although he had 
not received settlement from the insurance company, he had been ad- 
vised that the insurers would pay all costs up to $16,500 on the basis of 
their appraisal of the property at the time of the loss. The damage was 
not such as to require the hosiery shop to be closed down even while 
the repairs were being effected. The question of compensation for the 
inconvenience caused to the shop's business by the repairmen had not 
arisen, and Roland, having been in close contact with the tenant during 
this time, was sure that it would not come up in the future. 

Fortunately, on the advice of his insurance broker, Kraft had ordered 
a three-year full coverage policy written on both parcels of property and 
had paid a $780 premium at the time that the coverage went into effect 
on May 1. 

Roland found a note in his papers from the bookkeeper of the lumber 
company advising him that employees of the lumber and building supply 
firm had spent a total of 310 working hours (on company time) at the 
Moundsville property assisting in the repair work. These men had been 
paid on the regular firm payroll, and the bookkeeper estimated the aver- 
age value of the time spent was $2.50 an hour. 

Property Taxes: Both parcels of property were on school and village 



H. William Kraft 37 

tax assessment rolls. The taxes were paid once a year, due not later than 
July 1, for the ensuing twelve-month period. Both Mr. Kraft and the 
previous owner made the required payments on the due dates. On the 
basis of the information that he acquired from village records, and from 
his own disbursement records, Roland determined that the tax payments 
for 1957 and 1958 were as follows: 

MoundsvUle Herculaneum 

1957 $5,311 $3,306 

1958 5,601 3,544 

Other Information: Roland checked the file of invoices, paid and un- 
paid, and determined at year-end that the total value of bills that had 
not been paid was $740. ( This amount had been included in the calcula- 
tion of costs of operating the properties.) He also calculated that his own 
total pay from April 27 to December 31 was $2,430. To the best of his 
knowledge he had a complete file on all matters pertaining to the rental 
properties and the foregoing information was fundamentally what the 
year-end reports would have to be based upon. 

Roland wondered what he should state for the cash balance because 
Mr. Kraft had not established a separate bank account for the properties. 
Rather, he deposited all receipts in the regular firm bank account and 
made all disbursements from his regular business checkbook. He had 
at one time told Roland that, at least for the present, any funds that 
were needed to maintain the rental properties would be provided from, 
the funds of the lumber and building supply company. 



Required 

1. Prepare, for Mr. Kraft, the statements that William Roland must obtain 
from the information that he has to work with. Prepare the statements in 
the form that you feel will be most useful to Mr. Kraft. Justify the choices 
you make where alternative treatments are available. 

2. Assuming that Roland feels completely free to make suggestions to Mr. 
Kraft, what should he suggest? 



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CASE 7 



Berkshire 
Country Club 



Prior to its reorganization in 1947, the financial 
management of The Berkshire Country Club had 
been carried on in a haphazard manner, primarily by volunteer treas- 
urers. At this time, the club had been in operation for over 50 years, and 
was a focal point for the summer activities of a community in western 
Massachusetts, but despite the efforts of a number of members to adjust 
dues and charges for various services over a number of years to put the 
club on at least a break-even basis, the club had operated at a deficit 
in almost every year. These deficits had been made up by the donations 
of a few wealthy members, who informally assessed themselves a pro- 
rated share of the deficit. In the postwar years, the death of two of these 
members, together with increase in prices and a consequently larger 
deficit, forced a reappraisal of the club's traditional scheme of operations. 
Therefore, the club was reorganized in 1947, and at the same time the 
entire program of dues and charges was re-examined, in an attempt to 
(a) place the operations of the club on a self-sustaining basis, (b) to 
provide capital for the expansion of club facilities, and (c) to make 
the facilities of the club available to a larger number of summer residents 
through a proposed reduction in annual membership dues. 

In the Fall of 1956, Mr. William Victor was asked to serve as treasurer 
for the following two years. Mr. Victor had been a member of the club 
for a number of years, and was a partner in a successful insurance broker- 

40 



Berkshire Country Club 41 

age firm in Providence, Rhode Island. After agreeing to serve as treasurer, 
he discussed the club's accounting procedures with the past treasurer, 
a retired lawyer. The past treasurer's secretary, who had maintained the 
records of the club for the past three years, was present at the meeting 
in which the following basic procedures were outlined. 

The essential records of the club consisted of a cash-receipt and cash- 
disbursement journal, a general ledger, a 5 x 7 card file for each member 
to record accounts receivable (Exhibit 1), and a paid and unpaid file 
of invoices. 

The cash receipts journal contained the following entries: 

Debits: 

Cash 
Credits: 

Membership Dues 

Junior Activity Dues 

Excise Tax 

Green Fees 

Guest Fees 

Locker Rentals 

Entertainment Revenue 

Dining Room Sales 

Snack Bar Sales 

Miscellaneous Receipts 

The cash disbursements journal contained these account columns: 

Credits: 

Cash 

Withholding Taxes 

Social Security 
Debits: 

Dining Room— Purchases and Supplies 

Payroll— Pro 
—House 
—Junior Activity 

Snack Bar Purchases 

Entertainment Exp. 

Club Expense, General 

Junior Activity, Exp. 

Miscellaneous 

Entries in the journals were made only upon receipt or expenditure of 
cash. Totals of the journal were posted to the ledger accounts monthly, 
with the Miscellaneous columns posted in some further detail as indi- 
cated by the income and expense items on the operating statement (see 
Exhibit 3). 

Billings for regular membership dues were prepared by the secretary 
(based on the preceding year's membership classification and any in- 
formal notifications of changes in status), using the approved member- 



42 Berkshire Country Club 

ship rates (see Exhibit 2). Copies of these bills were filed and total 
charges for each member were posted to a 5 x 7 card ( Exhibit 1 ) . When 
the dues were paid, the cash receipt was entered in the cash receipts 
journal, the copy of the bill marked PAID and the payment entered on 
the file card. Sometimes members would reclassify themselves, change 
the bill and make their payment of the new amount. In these cases the 
secretary accepted the reclassifications and noted the change on her copy 
of the bill. 

The secretary billed separately for the Junior Activity dues, but used 
the same procedure as for Membership Dues. The charge was $40 plus 
excise tax for each child. The Junior Activity consisted of an organized 
program for children (age 8 to 13) of Club members and was intended 
to be self-sustaining. The chairman of the Junior Activity sent to the 
secretary, monthly, any bills for expenses incurred in the program. Some- 
times these represented payments to other club members, and in these 
cases the secretary simply gave the member credit on his monthly ac- 
count ( see June 1 credit entry on Exhibit 1 ) . The chairman also reported 
monthly, by letter, any additional charges, such as guest fees. 

The Club Manager prepared a list of charges by members for pur- 
chases of Snack Bar cards by members of their families, and for meals 
in the Dining Room. The Snack Bar cards of $2.50 and $5 values were 
punched out as purchases were made in the Snack Bar. The secretary 
used these reports to prepare monthly statements using the following 
form. 



THE BERKSHIRE COUNTRY CLUB 
MONTHLY BILL 



TO: 

Charge: 



Snack Bar 

Dining Room 

Entertainment 

Miscellaneous charges or credit 



Total: 



The Club Manager also sent invoices to the secretary monthly for 
payment. In most instances he indicated the club activity to which the 
expense should be charged. For example, on a grocery bill of $100, he 
usually indicated that portion applicable to Snack Bar and Dining Room. 
However, the demands on the Club Manager's time during the summer 
were great and quite often the secretary was required to use her own 
judgment as to which account to charge for these disbursements. This 
fact partly explains the substantial amount in the General Club Expense 
account. In addition, the Club Manager's Petty Cash fund was replen- 



Berkshire Country Club 43 

ished and charged to this Club Expense account without voucher support. 

An Entertainment Committee was responsible for all special events, 
such as square dances, camp-fire suppers and barbecues. The Committee 
set the fees on each event with the intent to break even on an out-of- 
pocket basis. The Committee Chairman reported to the secretary the 
members attending and the amounts to charge. The report usually showed 
the total cost of the activity, but the bills were sent in by the Club Man- 
ager for payment. The secretary made the charge to the activity from 
these invoices, rather than from the Committee Chairman's report. 

The Bar Committee was established during the 1956 season to oper- 
ate bar facilities for the purpose of expanding these facilities through the 
profits of the activity. The entire operation was accounted for independ- 
ently of the Club records. The $750 reported on the Operating Statement 
was part of the net gain of $1,051. The balance was retained by the com- 
mittee as working capital. 

Following the discussion of the procedures, Mr. Victor reviewed the 
records and prepared a tentative statement of Income and Expense. This 
statement and excerpts from his memorandum to the Governors are re- 
produced in Exhibit 3. 

Required 

1. In view of the objectives as reported in the treasurer's memorandum, 
what changes would you make in the system? Why? 



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44 



EXHIBIT 2 



Membership Dues Schedule 

THE BERKSHIRE COUNTRY CLUB 



TO 



Bill for Dues - 1956 Season 

ACTIVE MEMBER: 

Over 21 and under 36 years of age as of June 1st (entitled 

to full privileges of Club for self and immediate family 

except green privileges) $40.00. 

36 years of age or over as of June 1st (entitled to full 

privileges of Club for self and immediate family except 

green privileges) 75.00. 

NONRESIDENT MEMBER: 

Available to persons eligible for Active Membership who 

do not reside for any part of the Club season within 20 

miles of the Club (entitled to access to Club House and 

grounds - no green privileges) 15.00_ 

SUSTAINING MEMBER: 

Available to an individual otherwise eligible for Active 
Membership 60 years of age or over as of June 1st (priv- 
ileges limited to access to the Club House and grounds 
and Club social functions only - no green privileges) 35.00. 

GREEN FEES: 

Active and Sustaining Members (self and immediate fam- 
ily for the season) 50.00. 

Nonresident Members 30.00. 

Guest charges of $3 per person per game will be billed monthly. 

LOCKER RENTALS: 

Active and Sustaining Members (per locker) per year 5.00. 

Nonresident Members (per locker) per year 7.50. 

ALL CHARGES except where shown otherwise are for the entire 
season. If membership privileges are desired for one month they 
are available at two-thirds the full season rate. 

TOTAL CHARGES 



45 



EXHIBIT 3 



Excerpts from the Treasurer's Report 

THE BERKSHIRE COUNTRY CLUB 

MEMORANDUM 

To: The Governors December 10, 1956 

From : The Treasurer 

With apologies for taking so long, I submit herewith a tentative state- 
ment of Income and Expense for the 1956 season's operations. Under the Club's 
present system of accounts, available data do not lend themselves readily to 
analysis of results until the books are closed on March 31 at the end of our fiscal 
year. The figures presented here are derived from a reconstruction and consoli- 
dation of cash receipts and disbursements, and accounts payable and receivable. 
I have little doubt that some of them may be in error to varying degrees because 
I have not had the time to trace through the individual accounts one by one, but I 
am fairly confident that they are not inaccurate to any significant measure. The 
secretary has been most cooperative and helpful, and the postings to the various 
accounts appear to be very accurate. 

It would doubtless be possible to construct also a tentative balance 
sheet with the data available; however, lack of time has prevented my doing this 
and, in addition, there doesn't seem to be any pressing need for one at present. 
The salient balance sheet items would show, as of December 1, 1956: 

Cash $4,058.99 

Accounts receivable 2,783.69 (Billing to Members) 

Accounts payable 993.09 (Trade bills, accrued taxes) 

A payment of $750 was made during the fiscal year to date to reduce the princi- 
pal of the outstanding mortgage. In addition, payments associated with the ex- 
pansion of the Bar and Dining Room were made in the amount of $3,533.68. 

It appears that some changes in the Club's system of accounts and 
accounting procedures will probably be desirable for the coming season. Both 
the nature and scope of activities have changed in recent years; these changes 
suggest a need for information more timely than that now available, and in a 
form which permits inspection of the performance of the various functional ac- 
tivities on an individual basis. It is also highly desirable that this objective be 
accomplished without a material increase in the demand upon the time of those 
individuals who play a part in the record -keeping process. I am doing some ex- 
perimenting on a possible revised system, and plan to present a firm plan to the 
Governors well before the start of the 1957 season. . . . 

... In summary, it seems to me that the major item of concern is to 
bring our expansion program and profitability in line for the coming years. This 
would seem to involve an upward revision of income via some combination of 
dues, meal and refreshment prices, and possible new charges, or a downward 
revision or stretchout of planned expenditures, or both. Since the recent philos- 
ophy of the Club's operations has, with proved success, emphasized lower dues, 
removal of some ancillary charges, and meal and refreshment pricing closely 
tied to costs, the governors will probably approach the problem of increasing 
rates with considerable circumspection. My own feeling in this regard is that 
any increases should be built around user charges rather than undiscriminating 
raises in dues, etc. At any rate, the decisions on the above suggested courses 
of action are clearly not for me to make, but the appropriate people should con- 
tinue to think about them. I'll be glad to try to supply any figures which might 
help this thought process. Finally, any comments you have will be most welcome. 



46 



EXHIBIT 3, cont'd 



Enclos^t 

THE BERKSHIRE COUNTRY CLUB 

Preliminary (Unaudited) Statement of Income and Expense— 1956 Season 

Income 

Dues, membership $16,679.01 

Dues, Junior Activity 4,519.25 

Dues, gross $21,198.26 

Less: Excise tax on dues 4,567.36 

Dues, net $16,630.90 

Guest fees 274.42 

Green fees 6,578.00 

Rentals 490.25 

Snack bar sales 3,734.51 

Dining room sales, gross $ 3,406.11 

Less: M.O.A.T.* 155.74 

Dining room sales, net 3,250.37 

Entertainment revenue 3,003.81 

Gifts— Private party 75.00 

Tennis tournament charges 71.25 

Miscellaneous receipts 654.81 

Receipts from bar committee ....... 750.00 

Total Income $35,513.32 

Expense 

Meals, purchases, and supplies $ 3,319.35 

Pro salary! 3,500.00 

Payroll, house 4,224.66 

Junior activity 3,843.75 

Snack bar, purchases! 2,657.18 

Administrative expense 1,384.60 

Entertainment expense 3,167.85 

Club expense, general 1,565.85 

Junior activity expense 449.94 

Taxes, property, and licenses 1,454.22 

Insurance premiums 1,483.24 

Interest payments on mortgage 240.00 

Prize purchases, tennis 224.00 

Audit expense 60.00 

Repair and maintenance 

Golf course $ 3,237.48 

House 1,974.54 

Tennis courts 1,262.62 

Repair and maintenance— Total 6,474.64 

Miscellaneous expense 46.58 

Total Expense $34,095.86 

Excess— Income over Expense . 1,417.46 

*By special permission, the Massachusetts Old Age Tax has been paid to the 
state as collection on Dining Room Sales are made. Next year M.O.A.T. must be 
paid by the tenth of the month following the sale of meals, regardless of whether 
collection has or has not been made on such sales. 

fThe Golf Pro is in residence only during the summer months. In addition to 
salary, he has the concession for all golfing equipment and supplies. 

JThese purchases include some sporting supplies, which are not carried in 
the Pro's Shop, such as Ping-Pong and tennis balls. 



47 



CASE 8 



Pearson's 

Department Stores, Inc. 



4 4 "X7" oung man, I didn't hire you out of business 
I school to waste my time with damn fool sug- 
gestions." The speaker was Don Pearson, Chairman of the Board, presi- 
dent, and major stockholder of Pearson's Department Stores, Inc., of 
Phoenix, Arizona. He was addressing Dennis Clements, a new employee, 
who had recently joined the company after his graduation, in June 1959, 
from a large eastern business school. "You accountants are all the same. 
Always looking at the rule book. Anything different frightens you. Now 
listen to me. I built this business myself without any help from ac- 
countants— or department store experts; in fact, despite them and their 
ideas. I believe in my own ideas, and I hired you because with your 
record you should be able to bring some imagination to your work. Now 
if you seriously want me to think that the only new idea you've come 
up with in your first month here is for my company to change its fiscal 
year, come back here in a week with a full presentation. 

"I'm quite happy with our October 31 closing date. We've had that 
since we started. I don't want to start messing around with changing 
dates. Why should I? You'd better have some pretty good reasons next 
week. If you're not going to do your job the way I like it, you can go 
sell shoes. Accountants! I should never have allowed any of them around 
this place!" 

48 



Pearson's Department Stores, Inc. 



COMPANY BACKGOUND 



Don Pearson had moved to Phoenix soon after his separation from 
the Navy after World War II. Using his savings, he rented a small store 
and set himself up in business as "Dons TV." He had some training in 
electronics, and his aim was to build up a TV service shop, and then to 
branch out into TV sales after he had become known in the Phoenix 
community. 

Business was slow for the first few years. Then, in 1949 a local ap- 
pliance dealer went into bankruptcy, and Mr. Pearson purchased twenty- 
five TV sets from him at a big discount. This was a calculated risk, be- 
cause he could not afford to have his working capital tied up in excessive 
inventory for too long. His solution was quite logical, he thought. He 
reasoned that handling the extra sales volume would hardly add anything 
to his costs of doing business. This meant that he could offer the sets 
at substantial discounts below their normal price (hoping that customers 
would be attracted, as he had been, by the low price), and still make 
a fair profit. Because he was selling at such low prices, he would insist 
on full cash payment at the time of sale. 

The experiment was a resounding success. The twenty-five sets were 
sold in a matter of days, and customers continued to clamor for more 
low-price sets. Mr. Pearson, who was very aggressive by nature, decided 
that this was his opportunity to get into TV retailing. He arranged for 
a loan from members of his wife's family, rented a new store, and set 
about looking for more TV sets. He analyzed his first success into four 
rules: (1) good quality sets, (2) low markup, (3) cash sales only, and 
(4) rapid inventory turnover. He decided to keep to these rules, as they 
seemed to assure him of a satisfactory profit, and yet to differentiate his 
business, in the public's eyes, from that of the ordinary dealer. 

The next five years saw expansion beyond Mr. Pearsons wildest 
dreams. Literally, his sales volume doubled each year. Although he some- 
times found it difficult to obtain merchandise for resale at low prices, 
he was usually able to get around the manufacturers' attempts to keep 
their products from him, or to restrain him from selling at below normal 
prices. During this period he set up a number of new stores in other 
cities in the West and Southwest, including Tucson, Albuquerque, Ama- 
rillo, Denver, Salt Lake City, and San Diego, all run on the same lines 
as "Don's TV" in Phoenix. At the same time, he found that he was 
under considerable pressure from his customers to broaden the lines he 
carried. First as personal favors, and later as store policy, he began to 
stock radios, refrigerators, home freezers, and other electrical appliances, 
selling them all under his basic, original rules. 



50 Pearson's Department Stores, Inc. 

DEVELOPMENTS IN 1955 

The only problem that Mr. Pearson could not handle with his own 
ingenuity was that of finance. Aggressive expansion required working 
capital, even though the stores maintained a high rate of inventory turn- 
over and offered no credit. By early 1955, although the capital employed 
in the business had grown considerably through the retention of earnings, 
and from sales of stock to Phoenix investors, he had come to the conclu- 
sion that some major outside financing would soon be required if the 
business were to continue to expand as planned. 

After numerous consultations with his legal counsel, and later with a 
group of investment bankers, he finally decided to have a public stock 
offering at the end of the year. No alternative means of financing seemed 
feasible. As it was, the local bank was not too ready even to provide 
short-term, self-liquidating credit to finance inventory build-ups, as they 
felt that, despite its expansion, the company had not yet grown to fi- 
nancial maturity. They suggested that the addition of more permanent 
capital would improve the company's financial position (as disclosed in 
its annual financial statements) and make it easier for them to rate the 
company a good credit risk. 

The new capital would become available at just the right time to 
sustain a radical change in the nature of the company's business, planned 
by Mr. Pearson. As an experiment, he had installed men's and women's 
clothing departments in the Phoenix store in February 1955. This in- 
novation had met with a great reception from the public, who were ap- 
parently ready customers for discounted merchandise of any type, if the 
quality was good enough. When the new idea was tried out at the other 
stores, it worked equally well. With typical disregard for convention, 
Mr. Pearson decided that his next major expansionary move would be to 
convert his stores into full-range department stores. Not only would he 
strengthen the appliance departments, but he would also introduce a 
great variety of soft goods, sporting goods, toys, toilet goods, and food 
lines (in supermarket annexes). In line with this decision, and to add 
a little aura to the forthcoming stock issue, he changed the name of his 
company to Pearson's Department Stores, Inc. 

The stock offering came to the market in December 1955. The offering 
was successful, and $2,250,000 was received by the company after deduc- 
tion of all expenses of the 100,000 share issue. 

CONVERSION TO DEPARTMENT STORES 

The decision to convert the company's appliance stores to full-range 
department stores was carried out with little delay. By the end of 1956, 



Pearson's Department Stores, Inc. 51 

the required building alterations and extensions had been completed. 
For management purposes, Mr. Pearson decided to distinguish between 
two broad classes of merchandise carried in his stores: hard goods and 
soft goods. 

Hard goods included mainly the appliance side of the business, al- 
though, for convenience, Mr. Pearson included in this category small 
lines such as food. He regarded this category as the backbone of the 
business. By and large, hard goods sales tended to grow steadily, month 
by month, with little cyclical influence. On the average, Mr. Pearson tried 
to maintain hard goods inventories at the expected amount of the next 
forty-five day's sales. 

Soft goods included mainly the numerous clothing departments. Mr. 
Pearson expected that the bulk of his stores' expansion from 1955 would 
be accounted for by the hoped-for rapid growth of these new depart- 
ments. As a goal, he hoped that soft goods would amount to 50 per cent 
of total sales within ten years. Mr. Pearson realized that the soft goods 
sales pattern would show two strong trends over that period. He ex- 
pected vigorous annual growth, but he knew that he would have to expect 
regular seasonal fluctuations, since there were two traditional soft goods 
selling seasons each year, one ending January 31 and the other on July 31. 
Although he would try to avoid having more than forty-five days' sales 
in inventory, he knew that there would be heavy build-ups before each 
season's peak, and equally heavy inventory depletion as seasonal clear- 
ances were undertaken in preparation for the arrival of each new season's 
merchandise. 

When Dennis Clements started collecting some information that might 
be useful in assessing the proposed change in fiscal years, he was able 
to obtain sales and closing inventory figures from the time of the start 
of the department store phase. The figures are presented in Exhibit 3. 
He was also able to find the monthly sales and purchase breakdowns for 
the last complete fiscal year, the year to October 31, 1958 (Exhibit 4). 
No full and complete monthly financial statements were prepared by the 
company. 



DENNIS CLEMENTS 

Dennis Clements had first developed an interest in the Pearson cor- 
poration in May 1959, when he received a job offer from them shortly 
before his graduation from business school. His first move after receiving 
the offer was to telephone Graham Parker, a security analyst with a local 
brokerage firm. Mr. Parker filled him in on the background of the Pear- 
son corporation, and then Clements asked him if he knew anything about 
their financial history. 



52 Pearson's Department Stores, Inc. 

"Yes, I do," replied Mr. Parker, "but it's not very useful to me. I have 
all their figures. However, every time I try to analyze their statistics in 
relation to the major department store chains, I run up against a brick 
wall. For some unknown reason they use an October . 31 fiscal closing 
date, and I don't think there's another large retail chain in the country 
that does. 1 Believe me, it's a pretty sore point with our local group of 
security analysts. We get a lot of inquiries about the stock, and we just 
don't have any standard data by which to judge it. Look, Dennis, if you 
go to work for them, why don't you try to get them to change to a more 
reasonable date? I'm telling you, they're minor league as far as I'm con- 
cerned right now. I simply never know what to make of their figures- 
cutting right smack into the middle of the other stores' cycles. How would 
it be if I sent you a comparative analysis we made the other day? It'll 
help you appreciate our problem [see Exhibit 6]. By the way, I hear 
Don Pearson's quite a tiger. You want to be careful with him." 

Dennis Clements took the job offered to him, but Mr. Parker's words 
had made an impression on him. He thought to himself that if he could 
do something to help improve the company's reputation, it would start 
him off well. He had therefore approached Mr. Pearson, and had re- 
ceived the response reported earlier. It seemed as though he now had 
a project on his hands. 

TREASURERS VIEWPOINT 

The first person with whom Clements discussed his proposal, after 
talking to Mr. Pearson, was Mr. Antony A. Mills, the treasurer. Mr. Mills 
said that he could see advantages as well as disadvantages in a change. 
He understood the security analysts' problem, but he did not like the 
fact that any change by the company would mean an earnings report 
for a broken period, before the new twelve-month basis took effect. This 
odd period might distort the company's growth record. It would always 
have to be distinguished from prior and subsequent periods in all future 
financial summaries. Furthermore, it would obviously take some time 
before the company could develop a series of annual figures on the new 
basis, for use in its internal comparisons. Mr. Mills pointed out that 

1 The Harvard Business School Research Bulletin "Operating Results of Depart- 
ment and Specialty Stores in 1958" (Bulletin #155, June 1959) indicated that the 
fiscal closing dates of the 331 department stores included were as follows: 

Number of Stores Reporting for Years Ended 
Sales December 31, 1958 Jan. 31, 1959 Other 

Less than $1,000,000 38 63 5 

$l,000,000-$20,000,000 18 144 2 

More than $20,000,000 1 60 

"57" 267" 7 



Pearson's Department Stores, Inc. 53 

retention of the October 31 closing date would at least make for internal 
consistency. ( 1957 and 1958 Financial Statements are shown in Exhibits 
land 2.) 

Mr. Mills was also a little concerned that a new balance sheet date 
might be chosen at a time when a substantial amount of short-term 
borrowing would be outstanding. Such borrowing was purely temporary 
and self -liquidating in the company's case, as inventory built up and then 
was depleted. Disclosure of such indebtedness on the annual balance 
sheet might give a misleading view of the company's financial position. 
As an example of a typical year's loan transactions, he showed Clements 
the company's loan account with the South- Western National Bank for 
the 1958 fiscal year (Exhibit 5). On the average, the company paid for 
its purchases within a month of their arrival. 

TAX CONSIDERATIONS 

Dennis Clements also discussed the company's tax position with Mr. 
Mills. His specific concern was what effect a fiscal year change would 
have on the timing of income tax payments. Mr. Mills told him that the 
regulations were spread through a number of different sections of the 
Internal Revenue Code, but as far as Pearson's was concerned, they 
required that payments be made as follows: 

(1) On the fifteenth day of the ninth and twelfth months of the 
fiscal ( or taxable ) year, equal installments totaling 50 per cent 2 of the 
excess of estimated tax over $100,000; 

(2) On the fifteenth day of the third and sixth months following the 
close of the taxable year, equal instalments totaling the balance of the 
unpaid taxes. 

For taxable years less than twelve months (occasioned by a date 
change) the closing date of the short period would be regarded as the 
closing date of a regular taxable year, as far as due dates are concerned. 

Permission would be required for a date change, but Mr. Mills did 
not think that that would present any problem. 

EFFECT ON THE ANNUAL AUDIT 

When Mr. James D. Pettit, the senior partner of the company's firm 
of CPA's, was consulted, he pointed out that he would naturally accept 

2 Percentage is applicable to tax years ending on or after December 31, 1959. 
The period 1955 to 1959 saw an acceleration of tax due dates; the equivalent 
percentage for the year December 31, 1958, through December 30, 1959, was 
40 per cent; for the previous twelve months it was 30 per cent, and so on. 



54 Pearson's Department Stores, Inc. 

any date that the company chose. However, he emphasized that an im- 
portant part of his audit was the attendance of his staff at the year-end 
inventory-taking. Since Pearson's did not maintain any inventory or other 
records that could establish the amount of the closing inventory, it was 
necessary, in each store, for store personnel to list all merchandise in 
stock at the end of the fiscal year. This process usually took several days' 
concentrated effort. Established auditing procedures required the auditor's 
observance of the inventory-taking process, in these circumstances. This 
was necessary for the auditor to be in a position to form an opinion 
as to reliability of the amount stated as inventory in the financial state- 
ments. 

In the past, it had always been necessary for Mr. Pettit to hire addi- 
tional temporary help at Pearson's inventory time, so as to be able to 
carry out his duties properly. The CPA firms that reported to him on 
their audits of the stores in the cities outside Phoenix all experienced the 
same pressure at this time. However, if the company were to select a 
new date in the accounting profession's traditionally busy period, De- 
cember 31 to April 15 (the "tax season"), it would simply mean that 
the costs of the temporary help charged to the Pearson account might 
be higher. Conversely, a new date in the mid-year slack season would 
probably mean less strain on the CPA's staff resources, less overtime and 
quite possibly better quality auditing, if Mr. Pettit were able to put his 
better men on the account and thus also smooth out his own firm's work 
cycle. 

Mr. Pettit's total fee was currently around $60,000 per year (including 
work by out-of-town accountants ) . He said that a short fiscal year would 
mean no reduction in his fee. However, if the volume of work connected 
with inventory-taking, and, for example, the confirmation of accounts 
payable, were to be substantially reduced, he might be able to hold off 
for a year the usual $5,000 annual increase in his fee necessitated by the 
company's ever-increasing size. 

After his interview with Mr. Pettit, Dennis Clements thought that he 
had spoken to everyone that might be affected by a change to a new fiscal 
year. He could now go ahead and complete the assignment given to him 
by Mr. Pearson. 

Required 



1. Prepare a balance sheet at January 31, 1958, and at any other date in 
the 1958 fiscal year that you feel would have been suitable as a new fiscal 
closing date. (The liability for income taxes at any interim date should 
be the beginning liability on October 31, 1957, less any payments that 
would be made assuming the October 31 closing date remained in effect, 
plus accrued taxes on any earnings during the interim period. You may 



Pearson's Department Stores, Inc. 55 

assume equal monthly changes for balance sheet items where no specific 
information is given about the rate or pattern of change.) 

2. Which fiscal year date would be most favorable for Pearson's from the 
point of view of reporting financial data and ratios for comparison with 
competing department stores? 

3. Would you recommend that Pearson's fiscal year be changed? 



EXHIBIT 1 



Balance Sheets at October 31, 1957 and 1958 



1957 



1958 



Current Assets: 

Cash $ 1,305,000 

Inventories 10,275,000 

Notes and claims receivable 132,000 

Prepayments 169,000 

Total current assets $11,881,000 

Fixed Assets: 

Furniture, fixtures and improvements to 

leased premises, at cost 2,899,000 

Less: Depreciation 520,000 

Net fixed assets $ 2,379,000 

Other assets 474,000 

$14,734,000 

Current Liabilities: 

Accounts payable $ 5,862,000 

Accrued expenses and state and local taxes . 893,000 

Federal income tax 895,000 

Total current liabilities $ 7,650,000 

Stockholders' Equity: 

Capital stock ($2.50 par) 1,150,000 

Paid-in surplus 2,114,000 

Retained earnings 3,820,000 

Total stockholders' equity $ 7,084,000 



$14,734,000 



$ 1,413,000 

11,290,000 

164,000 

253,000 

$13,120,000 



3,795,000 

1,117,000 

$ 2,678,000 

173,000 
$15,971,000 



$ 7,035,000 
778,000 
399,000 

$ 8,212,000 



1,150,000 

2,114,000 

4,495,000 

$ 7,759,000 

$15,971,000 



EXHIBIT 2 



Income Statements for the Years 
Ended October 31, 1957 and 1958 



1957 



1958 



Net sales $60,314,000 $90,375,000 

Less: Cost of sales 48,304,000 72,235,000 

Gross margin* $12,010,000 $18,140,000 

Selling, general, and administrative expenses . . 9,929,000 16,769,000 

Profit before federal income tax $ 2,081,000 $ 1,371,000 

Provision for federal income tax 1,071,000 696,000 

Net profit $ 1,010,000 $ 675,000 

Retained earnings, beginning of year 2,810,000 3,820,000 

Retained earnings, end of year $ 3,820,000 $ 4,495,000 



♦Equivalent to a realized gross margin of 19.91% in 1957 and 20.07% in 1958. 
Mr. Pearson had standardized his pricing policy to aim for a 20% gross margin 
on all classes of merchandise. This policy was followed in 1959. Department 
stores run on traditional lines achieved a gross margin of about 36%, according 
to Mr. Pearson's information. 



56 



EXHIBIT 3 


Operating Data, 1955 
(Dollar Figures in Mi 

Sales 


to 1959 
llions) 

Closing Inventory 
Hard Soft 
Total Goods Goods 








Fiscal Year to 
October 31 


Total 


Hard 
Goods 


Soft 
Goods 


Net 
Profit* 


1955 


. $30.6 


$28.7 


$ 1.9 


$ 3.9 


$3.4 


$0.5 


$1.00 


1956 


. 46.7 


41.0 


5.7 


6.3 


5.2 


1.1 


1.32 


1957 


. 60.3 


48.9 


11.4 


10.3§ 


8.2 


2.0 


1.01 


1958 


90.4 


66.0 


24.4 


11.3 


7.7 


3.6 


0.68 


1959| 


. 111.5 


73.0 


38.5 


15.2 


9.6 


5.6 


1.84 


9 months to 
July 31, 1959f . . 


. 88.2 


59.1 


29.1 


t 


t 


i 


1.47 



*Net profit after tax. Operating expense levels were inclined to fluctuate 
widely during the 1955-1959 period owing to heavy and irregular start-up ex- 
penses associated with store expansion moves. 

t Estimated on the basis of trends through June 30, 1959. 

J Estimates not available. 

§ Discrepancy due to rounding. 



EXHIBIT 4 



Monthly Sales and Purchases Data, 1958 Fiscal Year 
(Dollar Figures in Millions) 







Total 


Hard Goods. 


Soft Goods 




Sales 


Purchases 


Sales 


Purchases 


Sales 


Purchases 


1957 
November 


$ 7.5 


$ 5.6 


$ 6.0 


$ 3.4 


$ 1.5 


$ 2.2 


December 


10.0 


4.9 


6.2 


3.85 


3.8 


1.05 


1958 
January 


4.6 


3.5 


4.1 


3.2 


0.5 


0.3 


February 


6.5 


8.2 


4.6 


4.6 


1.9 


3.6 


March 


8.4 


8.0 


5.4 


4.8 


3.0 


3.2 


April 


9.2 


6.6 


5.8 


4.6 


3.4 


2.0 


May 


8.5 


5.0 


5.9 


4.4 


2.6 


0.6 


June 


7.6 


4.95 


5.8 


4.5 


1.8 


0.45 


July 


6.0 


4.9 


5.3 


4.5 


0.7 


0.4 


August 


6.5 


8.0 


5.4 


4.6 


1.1 


3.4 


September 


7.4 


6.65 


5.6 


4.7 


1.8 


1.95 


October 


8.2 


6.95 


5.9 


5.0 


2.3 


1.95 




$90.4* 


$73.25 


$66.0* 


$52.15 


$24.4* 


$21.1 


♦Rounded totals, 
respectively. 


Exact totals are 


$90,375,000, $66,012,000 and $24,363,000 



57 



EXHIBIT 5 



Summary of Drawings and Repayments nder 
Revolving Credit Arrangement with the South- 
western National Bank, 1958 Fiscal Year 









Loan 




Drawn 


Repaid 


Balance 


1957 








November 2 


$1,500,000 




$1,500,000 


December 16 




$ 750,000 


750,000 


1958 








January 27 


750,000 




1,500,000 


March 16 


1,500,000 




3,000,000 


April 28 




750,000 


2,250,000 


May 29 




750,000 


1,500,000 


July 28 




750,000 


750,000 


September 15 




750,000 


- 




$3,750,000 


$3,750,000 





58 



EXHIBIT 6 



Comparative Statistics, Pearson's and Five Other 

Department Store Chains* 

(Dollar Figures in Millions) 





Pearson's 


Allied 


Federated 


R.H. Macy 


May Dept. 






Department 


Stores 


Department 


& Co., 


Stores 


J.C. Penney 




Stores, Inc. 


Corp. 
Follow- 


Stores, Inc. 
Nearest 


Inc. 


Company 


Company 




Nearest 


1958- 






ing 


Saturday to 


Saturday 




Jan. 31, 1959; 


Fiscal 




January 


January 31 


to 


Following 


Previously 


Year: 


October 31 


31 


Following 


July 31 


January 31 


December 31 


Salest 






1958 


$90 


$644 


$653 


$456 


$541 


$1,410 


1957 


60 


633 


636 


448 


534 


1,312 


1956 


47 


616 


601 


398 


521 


1,292 


1955 


31 


582 


538 


376 


494 


1,220 


1954 


15 


544 


501 


340 


444 


1,107 


Working 














Capital t 














1958 


4.9 


139 


135 


68 


121 


207 


1957 


4.2 


145 


126 


71 


116 


211 


1956 


3.9 


149 


123 


59 


113 


188 


1955 


1.2 


149 


110 


67 


112 


183 


1954 


n.a. 


130 


96 


59 


105 


176 


Current 














Ratio § 














1958 


1.6 


3.4 


3.4 


2.9 


2.7 


2.6 


1957 


1.6 


3.5 


3.3 


2.4 


2.6 


2.4 


1956 


1.7 


3.5 


3.1 


2.3 


2.7 


2.3 


1955 


1.2 


3.5 


3.1 


2.8 


2.8 


2.2 


1954 


n.a. 


3.5 


2.9 


3.0 


2.9 


2.3 


Inventory If 












1958 


11.3 


91 


69 


51 


62 


193 


1957 


10.3 


93 


66 


55 


62 


186 


1956 


6.3 


95 


66 


48 


57 


180 


1955 


3.9 


88 


58 


41 


59 


180 


1954 


n.a. 


77 


51 


37 


52 


142 


1953 


n.a. 


69 


49 


35 


51 


143 



♦Taken from published financial statements. 

t For fiscal years named. 

t Current assets less current liabilities at end of fiscal year. 

§ Ratio of current assets to current liabilities at end of fiscal year. 

11" At end of fiscal year. 

n.a. - Not available. 



59 



ANALYSIS OF FINANCIAL STATEMENTS 



CASE 9 



Brother-in-Law 



w 



ell, the mail can't be good every day. Today it's 
another letter from your brother-in-law. Seems 
like ever since you were admitted to business school, he's been acting 
like a junior-edition business consultant with an inside line (you) to 
the answer. Too bad sister is such a great gal or you'd really put this 
bird in his place. What does a guy have to do to keep peace in the 
family— better see what this letter says (read Exhibit 1). 

Just as you thought? Well, it could be worse; your big mistake was 
in sending him that pamphlet about the analysis of financial statements. 
It was way over his head. After all, what's a botany major fussing with 
debits and credits for anyway? Better set him straight, though. One 
thing sure, whatever you say will have to be in straight, easy-to-under- 
stand English; no financial double talk or you'll set him to spinning like 
a top. 

Best thing that you can do now is to pick up the I-H reports and do 
a little analysis work ( see Exhibits 2, 3, and 4 ) . Then drop "Brother Al" 
a line— clear and to the point, but make sure he gets it. Draw him pic- 
tures if you have to, but remember that if he doesn't get it, it's because 
of your explanation, and not because of his natural stupidity. 



60 



EXHIBIT 1 



Pittsburgh 
October 14 



Hi- 



Say, I've really got to thank you again for sending me that pamphlet. Ever 
since I received it I've been getting more interested in financial analysis all the 
time. Haven't finished reading the pamphlet yet — I've been too busy looking 
through the corporation annual reports in our library. And, did I ever come up 
with a good one — this looks like the blunder of the century, and I found it right 
in the published financial reports. 

I don't know how it got by them, but the boys at International Harvester sure 
missed a big one in the 1958 report. All the time— page after page— they're talk- 
ing about the profit they made even with conditions the way they were. You know 
the story. But somehow they accidentally let out that they lost over four million 
in working capital. I'd have swallowed that profit bit hook, line, and sinker until 
I saw the tipoff in working capital. How could they have muffed that one? It's sure 
easy to see that if working capital is going down you can't be making a profit. 

I'll write again if I find anything else that will interest you. Let me know 
what you think of this one. 



Keep up the good work, 

"fhotU/aC 



P.S. I'm going to write to the company; thought I'd let you know first. 
Shall I sign both our names? 



61 



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64 



CASE 10 



Ibbard Chemical 
Products Corporation 



Ibbard Chemical Products Corporation was, at the 
end of 1958, a large-scale manufacturer of chemi- 
icals and chemical products for a wide range of uses. Major applications 
for its products were found in the heavy industrial, agricultural, auto- 
motive, animal nutritive, pharmaceutical, and potable spirit fields. Its 
production facilities were located in five states; sales and warehousing 
facilities were operated in all major cities across the country. 

The company had, in recent years, placed considerable emphasis on 
the development of new products, as well as on a program aimed at 
achieving a high degree of diversification in the manufacturing facilities. 
Thus, in 1958 ICPC had a substantial investment in two major affiliated 
companies, and a lesser investment in several others. During that year 
it also made sizable investments in its own manufacturing and distribut- 
ing facilities. 

Comparative balance sheets for the company as of December 31, 1957, 
and December 31, 1958, are shown in Exhibit 1; an income statement 
for the year ended December 31, 1958, is presented as Exhibit 2. Addi- 
tional information about the company is given below. 

65 



Ibbard Chemical Products Corporation 



INVESTMENTS IN AFFILIATED COMPANIES 

By the end of 1958, ICPC's equity in the net assets of the Hydrotomic 
Corporation exceeded the cost of its investment therein by $656,256. 
The excess of ICPC's interest in that company's earnings, over dividends 
received, amounted to $28,883 in 1957, and $70,318 in 1958. 

The company's equity in Northern Chemical, as shown at cost in the 
balance sheet, represented a 42.7 per cent ownership interest. Since 
this affiliate commenced operations late in 1958, no appraisal of earnings 
performance was available. 

The corporation's equity in the net assets of another subsidiary was 
less than the cost of the investment therein (included in other invest- 
ments ) by $17,023. No dividends have been received from this subsidiary 
and ICPC's equity in its net loss for the year was $9,626. 

PRICE DETERMINATION AND RENEGOTIATION 

Certain of the corporation's sales in 1955 and 1956 were subject to 
price redetermination and, in the latter year, to renegotiation by the 
U.S. Government. Provisions for estimated price redetermination refunds 
were made in the accounts in the appropriate years, and in amounts 
which the managers considered adequate. During 1958, a compromise 
settlement was under consideration which would require payment of 
some $299,444 in excess of the amounts previously provided. The addi- 
tional amount was entered as a charge against operations in 1958 as an 
extraordinary item, and was credited to a current accrued liability ac- 
count. However, if government claims (which were made prior to the 
proposed compromise settlement and which ICPC has been contesting) 
should be allowed, the net amount refundable would be approximately 
$513,000 in excess of the amounts thus far provided. 

DEFERRED FEDERAL INCOME TAXES 

In its financial statements, ICPC computed the provisions for deprecia- 
tion and amortization by the straight-line method over estimated useful 
lives. For federal income tax purposes, however, those portions of plant 
facilities that were eligible for accelerated write-off were depreciated 
at rates in excess of normal straight-line rates. The excess of amortiza- 
tion and depreciation for tax purposes over straight-line depreciation 
resulted in a temporary tax reduction amounting to $943,200 in 1958. 
This amount was deducted from earnings and credited to the deferred 
tax account. The amounts so deferred were to be taken into income in 



Ibbard Chemical Products Corporation 67 

future years when the depreciation allowable for tax purposes was cor- 
respondingly less than provided in the financial statements. 



LAND, BUILDINGS AND EQUIPMENT 

In 1958 the company added to its investment in existing plant facilities 
in the amount of $3,567,571. At the same time that a program of addi- 
tional investment was being pursued, the company was also actively 
weeding out unproductive investments, particularly those in obsolete 
facilities. During the year, assets that were carried at a cost of $337,286 
(accumulated allowances there-against were $183,112) were sold for 
$146,780. Also, assets that had originally cost $72,487, and were fully 
depreciated, were written off the books. 

DIVIDENDS TO STOCKHOLDERS 

Holders of ICPC shares received both a stock dividend and a cash 
dividend in 1958. The cash dividend, paid quarterly, amounted to 
$2,382,520 and was completely disbursed by December 31. A stock divi- 
dend of 263,688 shares ($1 par, common stock) was distributed in July 
1958, and was recorded in the accounts at par. 

Required 

1. Prepare a funds flow statement (statement of sources and applications of 
funds) for Ibbard Chemical Products Corporation for the year 1958. 

Attention should be devoted to showing as much detail as possible, 
particularly concerning sources of funds from the disposal of fixed assets 
and uses of funds in the acquisition of new fixed assets. 

2. If on any given item in your funds flow statement you believe there are 
alternative treatments, explain concisely why you treated the item as you 
did. 



EXHIBIT 1 



Comparative Consolidated Balance Sheets 
December 31, 1957 and December 31, 1958 

December 31 Increase 

1957 1958 ( Decrease ) 
Current assets: 

Cash $ 7,981,231 $ 7,498,470 $ (482,761) 

Marketable securities (at cost) . . . 1,350,667 1,572,142 221,475 

Accounts and notes receivable (net) . 8,691,566 9,982,478 1,290,912 
Inventories (at lower of average 

cost or market) 11,626,511 11,937,430 310,919 

Total current assets $29,649,975 $30,990,520 $1,340,545 



Current liabilities: 

Accounts payable 

Accrued federal income taxes* 
Other accrued liabilities . . . 
Long-term debt (due in 1 yr.) 
Total current liabilities 



$ 3,818,885 $ 4,614,149 $ 795,264 

741,401 1,010,341 268,940 

1,931,974 1,689,178 (242,796) 

-o- 1,404,000 1,404,000 

$ 6,492,260 $ 8,717,668 $2,225,408 



Working capital $23,157,715 $22,272,852 $ (884,863 ) 

Investments at cost: 

Northern Chemical Corp $ 1,522,719 $ 1,522,719 $ -o- 

Hydrotomic Corporation 302,145 466,125 163,980 

Other affiliates 59,587 113,767 54,180 

Total investments $ 1,884,451 $ 2,102,611 $ 218,160 

Fixed assets: 

Land, buildings, and equipment 

(at cost) $59,054,850 $62,212,648 $3,157,798 

Less: Accumulated depreciation, 

amortization and obsolescence . . 26,499,124 

Net fixed assets $32,555,726 

Goodwill and patents $ 1 

Deferred charges 1,102,298 

Total assets less current liabilities . . . $58,700,191 



29,085,050 
$33,127,598 

$ 1 


2,585,926 
$ 571,872 

$ -O- 


901,341 
$58,404,403 


(200,957) 
$ (295,788) 



Less: Long-term debt and deferred 
taxes 

3 3/4% notes payable $22,500,000 $21,096,000 $(1,404,000) 

Deferred federal income taxes. 1,741,590 2,684,790 943,200 

$24,241,590 $23,780,790 $( 460,800 ) 

Balance for shareholders' equity .... $34,458,601 $34,623,613 $ 165,012 

Sources of shareholders' equity: 

Common stock - $1 par $ 5,934,107 $ 6,197,795 $ 263,688 

Additional paid-in capital 3,892,963 3,892,963 -o- 

Retained earnings 24,631,531 24,532,855 ( 98,676 ) 

$34,458,601 $34,623,613 $ 165,012) 



*These amounts are net of U.S. Treasury Tax Notes of $894,780 in 1957, and 
$261,000 in 1958. 



68 



EXHIBIT 2 



Statement of Consolidated Earnings 
Year Ended December 31, 1958 



Operating income $53,057,870 

Operating costs 

Cost of sales $38,978,427 

Selling, research, and administrative 6,267,513 

Depreciation and amortization 2,841,525 48,087,465 

Earnings from operations $ 4,970,405 

Other income: 

Dividends from Hydrotomic Corporation .... 256,532 

Miscellaneous other income 1,086,853 

$ 6,313,790 

Other charges: 

Loss on sale of plant assets $ 7,394 

Interest on borrowings 843,750 851,144 

Earnings before income taxes and extraordinary 

items $ 5,462,646 

Federal income taxes (including deferred taxes) . 2,615,670 

Earnings before extraordinary items $ 2,846,976 

Extraordinary items 299,444 

Net earnings for year $ 2,547,532 

Earnings retained at beginning of year 24,631,531 

$27,179,063 

Less: Cash dividends paid $ 2,382,520 

Stock dividends issued 263,688 $ 2,646,208 

Earnings retained at end of year $24,532,855 



69 



CASE 11 



Cole 

Appliance Stores, Inc, 



c 



ole Appliance Stores, Inc., operated a chain of 
small retail appliance outlets throughout the Mid- 
west. Comparative balance sheets for the company as of June 30, 1957 
and 1958, are shown in Exhibit 1. An income statement for the fiscal year 
ended June 30, 1958, is presented in Exhibit 2. Additional information 
about company activities during the year is given below. 

EXPANSION PROGRAM 

During the year the company opened eight new stores, purchasing the 
land and buildings in five locations and leasing store space in three other 
locations. Two old stores, judged to be inefficient, were closed down 
during the year. One of the stores closed for this reason was on a com- 
pany-owned location and the land and building were subsequently sold 
for $16,000. This building originally cost $22,000, and depreciation ac- 
cumulated at the date of sale was $14,000. The land had originally cost 
$6,000. The other store that was closed during the year had been in 
leased space. 

New equipment and fixtures were purchased for each of the eight new 
stores. The equipment in stores that were closed was sold to used- 
equipment dealers. In one store, the equipment had an original cost of 
$6,400, accumulated depreciation of $4,300, and was sold for $800. In the 

70 



Cole Appliance Stores, Inc. 71 

other store the equipment had an original cost of $8,200, accumulated 
depreciation of $5,600, and was sold for $1,500. 

APPRAISAL OF COMPANY-OWNED STORE LOCATIONS 

In order to substantiate the company's request for an increase in the 
amount of its mortgage loans, company officers hired an outside appraisal 
agency to determine the true value of certain company properties. As 
a result of this survey, the value assigned to buildings on the balance 
sheet was increased by $50,000. This was accomplished by a concurrent 
increase in the Capital Surplus account. The company planned to amor- 
tize this increase in value over a 25-year life by making the following 
two-journal entries at the end of each fiscal year: 

Depreciation and amortization expense $2,000 

Accumulated amortization— Buildings $2,000 

Capital surplus $2,000 

Earned surplus $2,000 

Company officers felt that this policy would allow a more accurate 
presentation of the financial position of the company at the end of each 
year and permit a more realistic statement of profits by charging against 
operations a larger amount for depreciation, reflecting the higher value 
of the assets being used in the business. This policy also was instrumental 
in helping the company secure additional mortgage loans (on old prop- 
erties as well as the five new locations) during the year. 

ACCOUNTING FROCEDURES FOR TELEVISION SERVICE CONTRACTS 

One of the sources of income for the company was television service 
contracts. These contracts normally ran for a one-year period after the 
sale of a set during which the company guaranteed to perform any neces- 
sary normal maintenance work on the customer's set free of charge. Sales 
of service contracts were initially recorded as liabilities, and each month 
one-twelfth of the price of the contract was transferred to the Revenue 
from Service Contracts account. 

ACCOUNTING PROCEDURES FOR INSTALLMENT SALES 

Approximately 70 per cent of the sales of Cole Appliance Stores were 
made on the installment plan, under which customers made an initial 
down payment and paid off the balance in equal monthly installments 
over a 12- to 36-month period. Company policy was to recognize the 
gross profit from installment sales as collections were received. This was 



72 



Cole Appliance Stores, Inc. 



done by determining the average percentage of gross margin earned 
on installment sales and recognizing as income this percentage of col- 
lections. For fiscal year (FY) 1958 the calculations were as follows: 



Balances, June 30, 1957 

Sales during FY 58 

Totals 

Collections during FY 58 

Gross margin recognized 

at 38% 

Balances, June 30, 1958 



Installment 
Accounts 
Receivable 


Per Cent Gross 
Margin 


Unrealized Profit 

on 
Installment Sales 


$48,900,000 
34,200,000 


37.9 
38.1 


$18,546,400 
13,031,600 


$83,100,000 
31,600,000 


38.0 


$31,578,000 
12,008,000 


$51,500,000 


$19,570,000 



DIVIDENDS 

Cash dividends paid during the year amounted to $2,100,000. In addi- 
tion, a 100 per cent stock dividend was distributed with no change in 
the par value of the stock. 

Required 



1. Prepare a funds flow statement (statement of sources and application of 
funds) for Cole Appliance Stores, Incorporated, for the fiscal year 1958. 

Particular attention should be paid to showing as much detail as possible 
in the funds flow statement concerning sources of funds from the sale 
of fixed assets and uses of funds in the acquisition of new fixed assets. 

If on any given item involved in your funds flow statement you believe 
there are alternative treatments, explain concisely why you treated the 
item as you did. 



EXHIBIT 1 



Comparative Balance Sheets, June 30, 1957 
and 1958 



Increase 

Assets : June 30, 1957 June 30, 1958 or (Decrease) 

Cash $ 2,310,000 $ 1,792,000 $ (518,000) 

Installment & misc. receivables . 51,418,000 54,336,000 2,918,000 

Inventories 18,109,600 18,873,000 763,400 

Prepaid expenses 25,800 23,100 (2,700) 

Total current assets $71,863,400 $75,024,100 $ 3,160,700 

Land buildings $ 687,000 $ 854,200 $ 167,200 

Equipment 372,000 444,000 72,000 

Total assets $72,922,400 $76,322,300 $ 3,399,900 



Liabilities and Capital: 

Notes payable 

Accounts payable 

Accrued expenses and taxes . 
Television service contracts 



500,000 


$ 500,000 


$ 


4,719,300 


5,644,300 


925,000 


3,720,000 


4,289,000 


569,000 


1,210,300 


1,326,000 


115,700 



Total current liabilities .... $10,149,600 $11,759,300 $ 1,609,700 

Mortgage loans payable $ 300,000 $ 400,000 $ 100,000 

Accumulated depreciation-bldgs. 281,500 287,500 6,000 

Accumulated amortization— bldgs. - 2,000 2,000 

Accumulated depreciation- equip. 139,600 170,200 30,600 
Reserve for unrealized profits on 

installment sales 18,546,400 19,570,000 1,023,600 

Common stock 10,000,000 20,000,000 10,000,000 

Capital surplus - 48,000 48,000 

Earned surplus 33,505,300 24,085,300 (9,420,000 ) 

Total liabilities and capital . . $72,922,400 $76,322,300 $ 3,399,900 



73 



EXHIBIT 2 



Income Statement for the Fiscal Year Ended 
June 30, 1958 



Revenues: 



Cash and regular charge sales 
Less cost of goods sold . . 



Installment sales $32,200,000 

Less cost of goods sold 21,168,400 

Total gross margin $13,031,600 

Less portion deferred until collected . . 11,892,300 
Plus: Margin realized by collections 

on prior year installment sales . . 

Television service contract revenue .... 
Less direct costs of contract fulfillment 

Total gross margin realized 



$10,417,000 

7,083,500 $ 3,333,500 



$ 1,139,300 
10,868,700 12,008,000 



$ 1,248,000 
712,000 



536,000 



$15,877,000 



Operating Expenses : 

Salaries 

Rent 

Building repairs and maintenance 

Property taxes 

Insurance 

Depreciation and amortization expense . . 

Loss on sale of fixed assets 

Advertising and promotion 

Miscellaneous general and administrative 
expenses 



Net profit before taxes 

Estimated federal income taxes 
Net income 



$ 6,782,000 

118,600 

84,000 

34,000 

20,000 

62,500 

400 

2,120,000 

1,237,300 10,459,500 



$ 5,418,000 

2,740,000 

$ 2,678,000 



74 



CASE 12 



Jensen 
Publishing House 



The Jensen Publishing House was engaged in the 
publishing and selling of scientific textbooks. Es- 
tablished in 1921 as a partnership, the business, although small, had 
prospered despite competition from larger concerns. By 1934 it had at- 
tained a gross volume of $112,500. In that year one of the two partners 
retired. The remaining partner, Mr. A. J. Jensen, continued the business 
as a sole proprietorship, borrowing $15,000 on a five-year 6 per cent note 
in order to buy out the interest of the retiring partner. Mr. Jensen hoped 
that the progress of the business would permit him to retire all or a 
large part of the payments on this debt from earnings; and in 1935 and 
1936 earnings were sufficiently large to make the realization of this hope 
quite possible. 

By the end of 1937, however, Mr. Jensen had become concerned about 
the state of the business. The operating statement for that year showed 
that, despite an increase in gross sales over 1936, net operating profit 
had declined and was so small as to make it seem highly improbable 
that Mr. Jensen's plans for retiring his debt could be carried out. Com- 
parative operating statements and balance sheets for 1936 and 1937 are 
shown in Exhibits 1 and 2. Mr. Jensen thought that it would be a good 
thing to have an analysis made of the unfavorable factors that had re- 
duced the profits of the business. Accordingly, he asked the outside 
accountant who made up his annual reports to include something on the 

75 



76 Jensen Publishing House 

matter. The report shown in Exhibit 3 was the result of this request. It 
provides a comparison between the years 1936 and 1937; the accountant 
believed this comparison would disclose the changes in various factors 
affecting profit that had led to the unfavorable result for 1937. 

The books published by the Jensen Publishing House were retailed at 
list prices which were not subject to change once they were announced, 
except for reductions made in efforts to liquidate excess inventories of 
slow-moving items. Bookstores were allowed trade discounts from the 
list price, the discount varying with the quantity ordered. The relation- 
ship between Jensen's wholesale and retail sales did not vary greatly. 
The gross margin used in computing the list price of a book varied with 
the length of the book, the difficulty of manufacture, the quality of paper, 
the number of illustrations, and especially with the estimated strength 
of the market for the book and with the number of copies printed. 
Royalties were determined by the drawing power of the author and by 
his bargaining ability; they were not subject to change once the original 
contract had been made. The amount of royalties due each author was 
computed and paid each month on the basis of copies sold in the preced- 
ing month. 

In addition to books of its own manufacture, sold either at wholesale 
or at retail by mail, the Jensen Publishing House sold books of other 
publishers at retail, also by mail. These books were always sold at the 
full list price, and Jensen obtained them direct from the publishers at 
a uniform discount of 20 per cent off list. As in the case of Jensens own 
books when sold at retail, postage was paid by Jensen. 

The Jensen Publishing House purchased all its typesetting, electrotyp- 
ing, printing, and binding service and therefore owned no printing plant. 
The business was so small that there was no distinct departmentalization 
of the publishing and selling functions; Mr. Jensen's time was divided 
among editorial, selling, and administrative duties. Two clerks and a 
shipper were the only employees. The concern occupied a suite of three 
rooms in a loft building; one was used for storage and shipping, another 
for a bookkeeping office, and the third for a general office and salesroom. 
Thus salaries, rent, light, heat, telephone, taxes, insurance, depreciation, 
and administration were fixed charges, which bore no relation to the 
volume of business. Advertising, travel, and delivery expenses ( including 
postage) varied approximately with the amount of business done. 

Required 

1. In your opinion, what was the state of Mr. Jensen's business at the end 
of 1937? If you had been called in as a consultant, what investigations 
would you have made? 



EXHIBIT 1 



Comparative Statement of Operations and Income, 
1936 and 1937 

1936 1937 



Sales 

Less cost of goods sold: 

Beginning inventory $11,677 

Paper, printing, and binding 8,930 

Amortization of printing plates* . . . 3,545 

Royalties 4,416 

Books purchased, net 39,660 

$68,228 
Final inventory 16,592 

Cost of goods sold 

Gross trading profit 

Less expenses: 

Administrative expense $ 7,854 

Selling expense 2,757 

Delivery expense 2,017 

Miscellaneous expense 353 

Total expenses 

Net operating profit 

Interest expense 

Net income 

A. J. Jensen, withdrawals 

Addition to net worth 



*In the book-publishing business, an electrotype plate usually is made of each 
page of a book after the type is set, and it is from these plates that the first and 
any later editions of the book are printed. Because of the heavy costs of setting 
type, a publisher normally has a large amount of money invested in plates. Since 
most books go "out of style" or are replaced by revisions in a limited period of 
time, the value of the plates declines rapidly. The cost of the plates of a particu- 
lar book were charged to operations over a three-year period. 



$70,768 


$16,592 

6,793 

2,152 

4,074 

41,173 


$73,027 


51,636 


$70,784 
13,976 


56,808 


$19,132 


$ 7,941 

2,477 

2,090 

451 


$16,219 


12,981 




12,959 


$ 6,151 




$ 3,260 


900 




900 


$ 5,251 




$ 2,360 


1,850 




1,850 


$ 3,401 




$ 510 



77 



EXHIBIT 2 



Comparative Balance Sheet 



Assets 

Cash % 

Accounts receivable 

Purchased books 

Manufactured books 

Supplies 

Total Current Assets 

Prepaid Insurance 



Dec. 3 


1, 1936 


Dec. 31, 1937 


$ 736 

5,467 

1,329 

15,263 

273 


$23,068 


$ 783 

6,496 

1,256 

12,720 

302 

$21,557 




180 


120 



Electrotypes at cost $ 6,087 $ 5,424 

less reserve 2,524 3,476 



3,563 1,948 



Fixtures $ 3,077 $ 3,077 

less reserve 1,339 1,614 



1,738 1,463 



6% 5-yr. note of 8/10/34 
TOTAL LIABILITIES 
NET WORTH 



TOTAL ASSETS $28,549 $25,088 



Liabilities 

Accounts payable $ 7,994 

Customers' advances 

Accrued wages 

Accrued rent 

Accrued electricity 

Accrued interest 

Total Current Liabilities 



$ 7,994 




$ 4,021 




46 




43 




73 




82 




150 




150 




28 




24 




125 




125 






8,416 




4,445 




15,000 




15,000 




$23,416 




$19,445 




5,133 




5,643 



$28,549 $25,088 



EXHIBIT 3 



Analysis of Changes in Loss and Gain Account, 
1937 and over 1936 



Sales increase $2,259 

Cost of sales increase 5,172 

Gross profit decrease $2,913 

Expenses of operating decrease 22 

Net operating profit decrease $2,891 



78 



CASE 13 



Industrial 
Uniforms, Inc.* 



6 4 XV" 7 hat are the purposes of these comparative fi- 
W nancial statements, and what are they to indi- 
cate to me?" This question greeted Bill Harris, the secretary-treasurer of 
Industrial Uniforms, Inc., as he entered the office of Roger Collins, presi- 
dent of the company. Spread out on the desk before Mr. Collins were 
the comparative balance sheets and income statements for the fiscal years 
ending in 1950 through 1956 and the monthly statements for fiscal year 
1956 (see Exhibits 1-4). These statements had been prepared by Albert 
Tryor, chief accountant, and submitted to Mr. Collins. 

Industrial Uniforms, Inc., was organized in 1932 by Henry Collins, 
Roger's father, as a distributor of industrial uniforms. The company was 
among the first to promote the use of matched industrial uniforms to 
replace ordinary work clothes of employees, especially for those persons 
having contact with the public. Initially the company handled the dis- 
tribution of the uniforms to the service station operators of one oil com- 
pany. From this small beginning the company had expanded rapidly. 
In recent months, in addition to major oil company service station at- 
tendants, regular sales were made to motor car dealer service depart- 
ments and driver salesmen for dairy, bakery, and bottling companies. 
The organization had built its reputation on high-quality merchandise 



Copyrighted 1956 by the Faculty of the School of Business, University of Kansas. 

79 



80 Industrial Uniforms, Inc. 

and quick delivery. By 1956 the operations of the company consisted 
primarily of retail mail order of industrial uniforms; approximately 80 
per cent of total sales were made directly to individual attendants, drivers, 
and other employees, or to their employers. 

The senior Mr. Collins had operated the company essentially as a one- 
man business, handling directly all matters of purchase, production, sale, 
and finance. In 1948 the business was incorporated with all stock being 
vested in the hands of Henry Collins and his three children. Henry Col- 
lins had actively continued in direct control of the company's operations 
until his death in March 1955. At that time Roger Collins, 37, principal 
stockholder, became president of the company. 

Roger Collins had been graduated from a large midwestern state uni- 
versity in 1940 with a degree in business administration, and since that 
time, had been associated with his father in the garment industry. Neither 
Roger's brother nor sister was directly associated with the operations of 
the company. Roger had been well trained by his father in all aspects 
of the uniform business and had given special attention to the sales 
function. As a step toward building a strong management organization 
for the still rapidly growing company, Roger made a number of organiza- 
tional changes and sought to delegate to other members of the manage- 
ment team some of the responsibilities his father had always insisted on 
keeping to himself. 

Bill Harris had assumed the duties of secretary-treasurer of the com- 
pany in May 1955. Prior to World War II, and after receiving his AB 
degree in political science in 1939, Bill had worked as an industrial 
engineer in a steel fabricating plant. After serving four years in the U. S. 
Navy, he was discharged with the rank of Lieutenant Commander. For 
two years after his discharge he worked in the retail sales business, 
following which he was employed by Industrial Uniforms, Inc., as a sales- 
man with the California Branch. He was transferred to the home office 
in 1950 where his time was divided equally between selling and ad- 
vertising. After about a year he withdrew from the sales activities and 
devoted full time to advertising and promotion. Harris had continued 
in this capacity until after Henry Collins' death. A full-time advertising 
manager was hired at that time, and Harris was transferred into financial 
control areas of the business. 

Industrial Uniforms, Inc., performed no manufacturing operations ex- 
cept to hem trouser legs to finished lengths, to order, and attach the pur- 
chasing company's embroidered insignia. The company purchased all the 
materials and findings and jobbed the actual production out to various 
garment factories at a flat rate per unit. The entire capacity of Waters 
Garment Company, a clothing manufacturer, was used by Industrial 
Uniform; other factories were called upon only when Waters was unable 
to meet the demands for stock. The daily production of Waters Garment 



Industrial Uniforms, Inc. 81 

Company averaged: shirts, 70 dozen; trousers, 60 dozen; coveralls, 25 
dozen; shop coats, 3 dozen; and jackets, 8 dozen. 

Industrial Uniforms, Inc., normally carried over 3,000 different stock 
numbers and sizes of finished garments in stock. For example: in each 
individual fabric and color, shirts were stocked in ten neck sizes with 
three varying sleeve lengths; trousers were stocked in fifteen waist sizes. 
Most of the matched uniforms stocked by the company were made of 
cotton; in the past three years, however, increasing quantities of synthetic 
materials and wool had been used. 

The company's chief accountant, Albert Tryor, who was about 45 
years of age, had been with the company for eight years. Comparative 
monthly and annual statements similar to those shown in Exhibits 1-4 
had been prepared for many years. In addition a schedule of the detail 
of the operating expenses was prepared monthly ( Exhibit 5 ) . The Daily 
Report Sheet ( Exhibit 6 ) was distributed each morning for the previous 
day's operations. 

Because many aspects of the financial and accounting operations of 
the business were still unfamiliar to him, Bill Harris had reviewed fi- 
nancial statements in some detail in preparation for discussions with Mr. 
Collins later in the week. Harris had not had an opportunity, in addition 
to his many other new duties, to gain as much familiarity with the 
financial operations of the company as he would have liked. 

Bill Harris was anxious to accumulate the additional information from 
Albert Tryor and others that would enable him to provide a meaningful 
explanation of the statements to Mr. Collins. He believed that he should 
be prepared to discuss the specific uses that could be made of the fi- 
nancial data in the planning and control of the company's operations, and 
offer recommendations for improvement in the company's financial con- 
trol data. 



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83 



EXHIBIT 3 



Comparative Balance Sheets 
At Month Ends for Fiscal Year 1956 



June 30 July 31 Aug. 31 Sept. 30 

Assets 1955 1955 1955 1955 
Current assets: 

Cash $253,662 $264,029 $168,444 $130,987 

Accounts receivable 127,215 96,911 97,143 121,630 

Inventory (lower of C/M) 

(See Exhibit 7) 413,242 425,337 481,620 568,426 

Total current assets $794,119 $786,277 $747,207 $821,043 

Deferred charges 14,600 12,536 11,777 19,231 

Stock in Collins Realty Co 

Plant and equipment: 

Land 2,000 2,000 2,000 2,000 

Buildings (net) 62,347 62,301 61,856 61,611 

Furniture & fixtures (net) 15,782 15,624 16,129 18,217 

Leasehold improvements (net) ..... 3,489 3,323 3,848 7,689 
Other assets: 

Cash surrender value of life 

insurance 3,361 3,361 3,361 3,361 

TOTAL ASSETS $895,698 $885,422 $846,178 $933,152 

Liabilities & Capital 
Current liabilities 

Accounts payable $ 44,945 $ 23,909 $ 39,656 $ 98,752 

Accrued taxes other than income 7,194 3,593 4,270 7,493 

Accrued Income Taxes 136,762 146,062 85,850 93,261 

Total current liabilities $188,901 $173,564 $129,766 $199,504 

Deferred income 15,500 7,719 7,079 15,573 

Due to officers 4,083 6,983 9,832 9,820 

Capital and surplus: 

Capital stock 100,000 100,000 100,000 

Capital surplus 65,400 65,400 65,400 

Donated surplus 13,835 13,835 13,835 

Earned surplus 587,979 517,921 520,256 529,019 

TOTAL LIABILITIES & CAPITAL $895,698 $885,422 $846,178 $933,152 

Source: Statements prepared by Albert Tryor, company auditor. 



84 



EXHIBIT 3, cont'd 



Oct. 31 Nov. 30 
1955 1955 



Dec. 31 
1955 



Jan. 31 
1956 



Feb. 29 Mar. 31 Apr. 30 
1956 1956 1956 



May 31 
1956 



$146,343 $126,815 $166,899 $158,012 
160,954 172,710 144,291 138,243 



$140,778 $164,950 $164,648 $ 268,036 
135,132 139,434 154,014 130,840 



527,426 523,263 

$834,723 $822,788 

9,584 7,860 



515,660 

$826,850 

6,316 



527,197 

$823,452 

4,075 



564,954 

$840,864 

3,606 



554,389 

$858,773 

9,545 



552,253 

$870,915 

577 



562,550 

961,426 

6,034 

7,500 



2,000 
61,366 
18,517 

7,523 



2,000 
61,121 
19,798 

7,357 



2,000 
60,876 
20,514 

7,191 



2,000 
60,631 
21,268 

7,025 



2,000 
60,386 
21,250 

6,859 



2,000 
60,141 
21,483 

6,693 



2,000 
59,896 
22,657 

6,527 



25,732 
5,878 



3,361 3,361 3,361 3,361 



3,361 



3,361 3,361 



3,594 



$937,074 $924,285 $927,308 $921,812 $938,326 $961,996 $965,933 $1,010,164 



$ 38,546 

5,305 

123,560 

$167,411 

28,532 

4,320 



$ 46,046 

7,225 

82,700 

$135,971 

24,503 

6,620 



$ 46,537 

9,999 

91,500 

$148,036 

13,665 

5,620 



$ 50,698 

5,001 

94,400 

$150,099 
6,071 
2,720 



$ 75,514 

5,578 

91,300 

$173,292 
3,029 
2,920 



$ 80,705 

11,211 

96,200 

$188,116 

3,554 

5,520 



$ 71,173 

7,195 

106,000 

$184,368 

9,699 

(2,280) 



$ 58,897 

7,521 

140,138 

$ 206,566 
2,589 



100,000 
65,400 
13,835 

557,576 



100,000 
65,400 
13,835 

576,956 



100,000 
65,400 
13,835 

580,752 



100,000 
65,400 
13,835 

583,687 



100,000 
65,400 
13,835 



100,000 
65,400 
13,835 



100,000 
65,400 
13,835 

594,911 



100,000 
65,400 
13,835 

621,784 



$937,074 $924,285 $927,308 $921,812 $938,326 $961,996 $965,933 $1,010,164 



85 



EXHIBIT 4 



Comparative Operating Statements 
for Months of Fiscal Year Ending May 31, 1956 

June July Aug. Sept. 

1955 1955 1955 1955 

Net sales $198,734 $141,416 $140,339 $196,995 

Beginning inventory $406,273 $413,242 $425,337 $481,620 

Purchases (net) 136,616 93,548 152,271 213,579 

Freight-in 1,817 1,929 2,849 3,833 

$544,706 $508,719 $580,457 $699,032 

Ending inventory 413,242 425,337 481,620 568,426 

Cost of goods sold $131,464 $ 83,382 $ 98,837 $130,606 

Gross profit on sales $ 67,270 $ 58,034 $ 41,402 $ 66,389 



Selling department expenses $ 12,260 $ 13,418 $ 14,246 $ 21,324 

Shipping department expenses 14,409 12,970 10,634 13,619 

General and administrative expenses .... 13,938 12,404 13,188 13,983 

Total operating expenses $ 40,607 $ 38,792 $ 38,068 $ 48,926 

Operating profit $ 26,663 $ 19,242 $ 3,334 $ 17,463 

Other income 750 



Net profit before income taxes $ 27,413 $ 19,242 $ 3,334 $ 17,463 

Provision for income taxes 13,700 9,300 1,000 8,700 

Net profit for period $ 13,713 $ 9,942 $ 2,334 $ 8,763 

Earned surplus -beginning of month 494,266 507,979 517,922 520,256 

$507,979 $517,922 $520,256 $529,019 

Dividends paid 

Earned surplus -ending $507,979 $517,922 $520,256 $529,019 

Source : Statements prepared by Albert Tryor, company auditor. 



86 



EXHIBIT 4, cont'd 



Oct. 
1955 



Nov. 
1955 



Dec. 
1955 



Jan. 
1956 



Feb. 
1956 



March 
1956 



April 
1956 



May 
1956 



$269,767 $271,281 $211,344 $185,633 $178,699 $207,236 $230,547 $233,731 



$568,426 

100,867 

1,480 

$670,773 
527,426 

$143,347 

$126,420 



$527,426 

172,377 

3,132 

$702,935 
523,263 

$179,672 



$523,263 

125,031 

2,367 

$650,661 
515^660 



__ $135,001 
$ 91,609 $ 76,343 



$515,660 

139,285 

2,101 

$657,046 
527,197 

$129,849 



$527,197 

173,245 

2,389 

$702,831 
564,954 

$137,877 



$564,954 

139,934 

2,335 



$554,389 

153,513 

2,425 



$552,253 

181,355 

6,748 



$707,223 $710,327 $690,356 



554^389 



552,253 



562^550 



$152,834 $158,074 $127,806 



$ 53,784 $ 40,822 $ 54,402 $ 72,473 $105,925 



$ 27,705 

21,015 

18,843 

$ 67,563 

$ 58,847 



$ 17,719 

14,996 

19,814 

$ 52,529 

$ 39,080 



$ 12,834 
22,272 
23,641 

$ 58,747 
$ 17,596 



$ 



19,180 
15,741 
15,028 
49^949 



19,453 
11,941 
15^465 



14,293 
11,715 
18,673 



$ 46,859 $ 44,681 
$ 5,835 $ (6,037) $ 9,721 



$ 17,128 

16,132 

20,073 

$ 53,333 

$ 19,140 



$ 19,038 

9,844 

16,032 

$ 44,914 

$ 61,011 



$ 58,857 $ 39,080 $ 17,596 $ 



30^300 



$ 28,557 $ 19,380 $ 8,796 



5,835 $ (6,037) $ 
2,900 (3,100 ) 



$ 2,935 
580,752 



9,721 $ 19,140 $ 61,011 



4^900 



9^800 



34JL38 



$ (2,937) $ 4,821 $ 9,340 $ 26,873 
583,687 580,750 585,571 594,911 



$557,576 $576,956 $585,752 $583,687 $580,750 $585,571 $594,911 $621,784 



$557,576 $576,956 $580,742 $583,687 $580,750 $585,571 $594,911 $621,784 



87 



EXHIBIT 5 



Monthly Statements of Operating Expenses 



For the month of 



March 


April 


May 


1956 


1956 


1956 


$ 4,538 


$ 6,022 


$ 5,608 


1,653 


2,485 


1,685 


4,076 


1,817 


5,840 


1,392 


4,569 


3,106 


2,054 


1,571 


1,889 


580 


664 


910 



January February 
1956 1956 



Selling department expenses: 

Commissions $ 4,623 $ 5,225 

Salaries 1,756 1,649 

Advertising & sales expenses . . . 8,733 9,354 

Travel 2,285 1,006 

California Branch 1,470 1,763 

New England Branch 313 456 

Total $19,180 $19,453 $14,293 $17,128 

Shipping department expenses: 

Salaries $ 8,134 $ 3,668 $ 3,749 $ 8,031 

Shipping supplies 1,738 2,155 2,125 1,889 

Miscellaneous shipping 725 559 703 488 

Heat, light, power, & water 171 235 213 197 

Calif ornia Branch 2,754 3,987 22,874 3,216 

New England Branch 2,219 1,337 2,051 2,311 

Total $15,741 $11,941 $11,715 $16,132 

General and administrative expenses: 

Executive salaries $ 4,954 $ 4,854 $ 5,331 $ 6,454 

Office salaries 4,852 4,971 4,884 8,072 

Taxes 608 657 1,257 682 

Insurance 1,752 1,866 1,721 1,893 

Office supplies 1,614 418 2,042 749 

Depreciation and amortization . . . 570 570 570 570 

Rent 106 106 211 141 

Dues and subscriptions 657 455 209 227 

Postage (537) 994 764 603 

Research 74 1 276 119 

Professional services 36 125 11 58 

Telephone and telegraph 128 135 158 172 

Employee welfare 45 5 4 

Utilities 183 95 140 133 

Bad debts (138) (10) (2) 

Contributions 15 20 5 

Miscellaneous 109 203 1,101 191 

Total $15,028 $15,465 $18,673 $20,073 



$19,038 



$ 3,968 

600 

61 

183 

3,282 

1,750 

$ 9,844 



$ 6,888 

5,644 

1,931 

(5,561) 

(226) 

1,508 

1,415 

28 

363 

1,069 

855 

384 

40 

113 

1,170 

278 

133 

$16,032 



Source : Statements prepared by Albert Tryor, company auditor. 



88 



EXHIBIT 6 



Daily Report Sheet 



1. Cash in bank 

Balance preceding day . . . 

Deposits 

Withdrawals 

Bank balance today 

2. Income Sales 

TODAY .... 

YEAR AGO . . 

3. Shipments 

TODAY .... 

YEAR AGO . . 

4. Production 

Waters Garment Company 
Lot No. Dozens 



Date 



Month to date . . . 
Month to date . . . 

Month to date . . . 
Month to date . . . 

Other companies 
Lot No. Dozens 



5. New York Spot Cotton Price Today . 



89 



EXHIBIT 7 



Merchandise Inventory by Months 
for Fiscal Year 1956 



Finished 
Goods 

May 1955 $320,835 

June 1955 331,350 

July 1955 309,445 

August 1955 382,734 

September 1955 412,750 

October 1955 396,214 



November 1955 
December 1955 
January 1956 . 
February 1956 
March 1956 . . 
April 1956 . . . 
May 1956 



411,419 
421,957 
460,780 
484,303 
486,091 
467,573 
517,482 



Original Cost 



Raw 
Material 



Total 



Market 
Value* 



$216,469 $537,304 $406,273 

201,466 532,816 413,242 

236,648 546,093 425,337 

246,869 629,603 481,620 

296,800 709,550 568,426 

243,146 639,360 527,426 

237,898 649,317 523,263 

221,121 643,078 515,660 

197,792 658,572 527,197 

217,065 701,368 564,954 

187,728 673,819 554,389 

207,152 674,725 552,253 

253,849 771,331 



* Market value as determined by the company is based upon liquidation value for 
all finished goods and goods in process. This is very low because most of these 
items are specialty merchandise stocked for special purchasers. 



90 



CASE 14 



Beldon 

Woolen Company (A) 



The loss and gain statement of the Beldon Woolen 
Company for the nine months ending September 
1, 1939, 1 showed a net loss of $151,025.24. 

Since 1937, the last good year of the Beldon Woolen Company, its 
operating statement had consistently shown an unfavorable manufactur- 
ing and marketing situation. Early in September 1939, with the submis- 
sion of the statement for the nine months of 1939 to the directors and 
stockholders of the company, the management proposed that the concern 
be liquidated. The plan was to liquidate the business "in an orderly 
manner," allowing reasonable time for the realization of the best pos- 
sible values. Manufacturing of unfinished goods was to continue until 
the end of December, when the assets of the business would be sold 
under receivership at the highest prices obtainable under the circum- 
stances. 

The balance sheet of the company as of September 1, 1939 is shown 
as Exhibit 2. 

Accompanying the above balance sheet was what the management 
had termed an "Analysis of Condition," the chief purpose of which was 
to segregate the amount of "net current" assets "available" to the holders 
of the company's stock and the amount of book value of plant similarly 



1 The company's fiscal year closed November 30. 

91 



92 Beldon Woolen Company (A) 

assignable to shareholders per share of stock held. This analysis was as 
shown in Exhibit 3. 

At the September meeting of the stockholders, the proposal of the 
management to liquidate the company was voted down, but with the 
understanding that if another six months' operations continued to look 
unpromising the liquidation plans would be reconsidered, probably at 
the regular stockholders' meeting scheduled for March 1940. Tied in 
with this action of the stockholders was a directors' decision to find a 
new general manager and president. By as early as the middle of the 
month the directors were able to make arrangements with suitable new 
personnel, and to examine with satisfaction the plans the newcomers 
were making to bring about helpful changes in the operating organization 
of the company. 

These changes were not only of a manufacturing character, but ex- 
tended also into marketing activities. Up to this time, the Beldon Com- 
pany had sold its product through a firm of factors in New York City. 
The new management believed that the company could do a much better 
job than had been done before through setting up its own selling organ- 
ization and handling its own promotional problems. On the production 
side they learned that during the last three years' operations "seconds," 
or substandard goods, had run as high as 22 per cent of total output. 
The general manager saw no reason why this ratio should not be reduced 
to a point as low as 1 per cent. Also, the new executives learned that a 
substantial portion of the company's stock of raw material was decidedly 
below standard quality. This fact, in addition to more or less obvious 
inefficiencies characteristic of the company's past manufacturing opera- 
tions, was among the considerations that led them to conclude that vastly 
much more could be done to make profits for the Beldon Company than 
had been done at least over the last half-a-dozen years of the company's 
existence. 

The task committee of the board that had been named to find the 
new executives had been fortunate to procure a general manager who, 
although idle at the time, had had some thirty-five years' experience in 
conducting woolen textile operations of almost the same character as 
those of the Beldon Woolen Company. Their man had built up a good 
reputation for himself as a vigorous and resourceful individual who 
prided himself on getting quick results that could stand the test of time. 

Toward the end of September the new president was able to prepare 
for the directors and stockholders a statement showing what the condi- 
tion of the company, under the new management, would "probably be by 
December 31, 1939." This statement (Exhibit 4) was intended to report 
on the results for the last quarter of 1939 that were expected to flow 
from the plans already put into effect to aid in the operating rehabilita- 
tion of the company. Of course this statement was expected to be ex- 



Beldon Woolen Company (A) 93 

amined in comparison with the September 1 "Analysis of Condition" that 
had been presented to the directors and stockholders early in September 
by the old management. 

Not long after the statement in Exhibit 4 had reached the hands of 
the stockholders of the Beldon Woolen Company, a number of letters 
and telephone calls were received by the president asking how it was 
possible that the net current position of the company could be expected 
to show an improvement of $8 a share by December 31. Much was said 
to the effect that if so favorable a change as this was to take place, it 
was certainly desirable under the circumstances to have the facts ex- 
plaining such gratifying results brought as clearly as possible to the 
attention of those who were responsible for deciding upon the long- 
range future of the company. In responding to these questions, the presi- 
dent requested the new management's auditors to clarify the statement 
of Exhibit 4, or rather to elaborate upon it in such a way as to answer 
the many questions which seemed to be bothering even friendly stock- 
holders. The auditor's addition to the figures of Exhibit 4 was as shown 
in Exhibit 5. 



Required 

1. Prepare a balance sheet as of December 31 comparable with that shown 
for September 1, under the title of "Analysis of Conditions as of September 
1, 1939." 

2. Explain how depreciation on plant could constitute a source of improve- 
ment in net current position. 

3. Explain where the auditor got his figure of "Profits on Inventory Realiza- 
tion." How could you explain the fact that the company was now expected 
to be so profitable? Would you have been satisfied with a report on ex- 
pected progress that was limited to the auditor's figures? 

4 Prepare a comparative balance sheet, containing the balance sheet as of 
September 1 and the projected statement for December 31; prepare your 
comparative statement so as to show net increases and decreases in assets 
and liabilities. 



EXHIBIT 1 



Loss and Gain 
Nine Months to September 1, 1939 



Manufacturing costs $2,641,920.80 

Selling costs 127,952.44 

Other charges 339,443.98 

$3,109,317.22 

Sales 2,946,768.71 

Trading loss $ 162,548.51 

Net income rent $ 8,008.27 

Miscellaneous gains 3,870.78 

Expense account 249.63 

$12,128.68 

Bad debts 605.41 11,523.27 

Net loss for nine months ' ' $ 151,025.24 



EXHIBIT 2 



Condensed Balance Sheet 
as of September 1, 1939 

Assets 

Plant $3,629,217.08 

Less allowed-for 

depreciation 1,236,095.97 

$2,393,121.11 

Cash 624,915.81 

Receivables 1,381,717.86 

Inventories . 1,340,068.60* 

Prepaid 

Insurance $61,148.65 

Interest 9,142.57 

Freight 3,721.36 74,012.58 

$5,813,835.96 



Liabilities 

Notes payable $2,192,154.00 

Accounts payable 17,057.32 

Interest accrued 13,326.84 

Taxes accrued 63,652.72 

Surplus $1,093,670.32 

Loss, 1939 151,025.24 942,645.08 

Capital stock 2,585,000.00 



$5,813,835.96 



*Cost or market of replacement, whichever is lower, with finished and partly 
finished goods of substandard quality at net disposal value. 



94 



EXHIBIT 3 



Analysis of Condition as of September 1, 1939 



Plant $3,629,217.08 

Less depreciation 1,236,095.97 $2,393,121.11 

Cash $ 624,915.81 

Receivables 1,381,717.86 

Inventories* 1,340,068.60 $3,346,702.27 

Prepaid $ 74,012.58 

Accrued 76,979.56 2,966.98 

$3,343,735.29 

Less notes and accounts payable $2,209,211.32 

Net current assets 1,134,523.97 

$3,527,645.08 

Par value of capital stock .... 2,585,000.00 
Surplus $ 942,645.08 
Net worth per share: Plant $92.58; Current, $43.88 



*Cost or market of replacement, whichever is lower, with finished and partly 
finished goods of substandard quality at net disposal value. 



EXHIBIT 4 



Condition of the Company as It Probably Will Be on 
December 31, 1939 



The following analysis of condition is based upon the assumption that produc- 
tion about as planned will be carried through, using up the process material on 
hand and purchasing the minimum amount of additional material necessary to 
supplement that now owned; and that such material as is not required for produc- 
tion will be sold. 

Net After 
Plant Depreciation $2,349,557.79 

Cash $720,000.00 

Prepaid insurance 30,000.00 

Inventory 360,000.00 

Receivables 980,000.00 $2,090,000.00 

Less notes payable $735,000.00 

Taxes and interest 

accrued 32,000.00 767,000.00 

Net current $1,323,000.00 

Net current per share $ 51.00 



95 



EXHIBIT 5 



Explanation of the Change in Net Current Value 

Per Share from September 1, 1939 to 
December 31, 1939, as Projected by the Report 
of the Management 

Sources of Working Capital Uses of Working Capital 

Profits on inventory 

realization $144,912.71 Increase in net current 

Depreciation on plant . 43,563.23 assets (as below) . . . $ 188,476.03 

$188,476.03 $ 188,476.03 

Increases in Net Current Assets 

Increase in cash $ 95,084.19 

Decrease in accrued liabilities 44,979.56 

Decrease in notes and accounts payable 1,474,211.23 $1,614,275.07 

Decrease in Net Current Assets 

Decrease in inventories $ 980,068.60 

Decrease in receivables 401,717.86 

Decrease in prepaid items 44,012.58 $1,425,799.04 

Net increase in net current assets (as above) $ 188,746.03 



96 



CASE 15 



Beldon 

Woolen Company (B) 



The Beldon Woolen Company had grown to be a 
fairly large organization under seven different 
managements extending over a period of approximately 100 years. By 
far the larger portion of its plant had been constructed building by build- 
ing, without the benefit of a long-range plan of plant development. The 
current president had taken over the control of the company, as already 
seen in Case 14 in the latter half of 1939, and among his plans for im- 
proving the company's operating efficiency were a number of proposals 
designed to concentrate and coordinate floor space facilities. In addition 
to plans for new construction and the purchase of new equipment, these 
proposals entailed the razing and scrapping or sale of a number of old 
buildings, the sale of land thus released, and the sale of obsolete ma- 
chinery and equipment. 

The financial effects of the proposed plant adjustments were, in round 
numbers, as follows: 

Sale of 5 building units (including land) $155,000 

Depreciated cost, $175,000 (gross, $300,000, 

reserve, $125,000) -land cost, $3,000 
Cost of scrapping 2 units (land to be used for new plant) 7,500 

Depreciated cost, $6,000 (gross, $10,000, 

reserve, $4,000) 
Old machinery and equipment sold (cost of removal 

$300) 18,000 

97 



98 Beldon Woolen Company (B) 

Depreciated cost, $23,000 (gross, $40,000, 

reserve, $17,000) 
Additional old machinery and equipment sold 50,800 

Depreciated cost, $33,000 (gross, $419,000, 

reserve, $386,000) 

New equipment bought 50,000 

New construction, involving rebuilding old units and 

adding two new structures 275,000 

Cost of moving 30,000 



Required 

1. The student is asked to show the effect of the expected plant adjustment 
transaction on the company's balance sheet as of September 1, 1939 (see 
Case 14). 

2. Below are the balance sheets of the Beldon Woolen Company for the year- 
ends December 31, 1939, December 31, 1940, and December 31, 1941. 
Suggest explanations for the principal changes in the company's balance 
sheet position from December 31, 1939, to December 31, 1940, and from 
the latter date to December 31, 1941. 



EXHIBIT 1 



Comparative Condensed Balance Sheets as of 
December 31, 1939, 1940, and 1941 

December 31, December 31, December 31, 

Assets 1939 1940 1941 

Current assets: 

Cash on hand and in banks .......$ 380,340.33 $ 205,721.75 $ 109,005.91 

Accounts receivable, less reserves 828,938.47 1,234,457.77 924,988.55 

Inventories, less reserves 748,827.90 1,280,780.73 1,300,809.94 

Return insurance premiums 

receivable (estimated) 40,636.72 32,542.87 ... 

Total current assets .... $1,998,743.42 $2,753,503.12 $2,334,804.40 



Investments $ 819.54 $ 5,709.23 $ 5,709.23 



Deferred charges: 

Unexpired insurance $ 8,647.52 $ 2,518.98 $ 13,227.22 

Prepaid interest and commission . . 722.00 13,722.49 ... 



Total deferred charges . . . $ 9,369.52 $ 16,241.47 $ 13,227.22 

Fixed assets: 

Book values $3,637,085.36 $3,313,407.14 $2,866,067.85 

Deduct-Reserve for depreciation 1,266,095.97 2,558,928.84 2,101,700.11 

Net book value of fixed assets $2,370,989.39 $ 754,478.30 $ 764,367.74 

Total $4,379,921.87 $3,529,932.12 $3,118,108.59 

cont'd 



99 



EXHIBIT 1, cont'd 



December 31, 
Liabilities 1939 

Current liabilities: 

Notes payable $ 970,000.00 

Accounts payable 

Advances from customers 

Accrued pay roll 

Accrued interest 10,703.25 

Provision for cost of finishing 

unshipped sales 21,242.64 

Provision for special commis- 
sions on unfilled orders ... 
Provision for state taxes ... 

Total current liabilities $1,001,945.89 

Capital stock- outstanding 2,585,000.00 

Surplus 792,975.98 



December 31, December 31, 
1940 1941 



$1,435,000.00 $ 225,000.00 
35,870.07 28,876.84 



20,580.35 
8,410.33 
7,941.75 

1,433.48 



3,542.83 

33,718.26 

5,120.50 

9,766.89 

20,000.00 
6,000.00 



$1,509,235.98 $ 332,025.32 



1,292,500.00 1,938,750.00 



728,196.14 



847,333.27 



Total $4,379,921.87 $3,529,932.12 $3,118,108.59 



100 



PART II 



Formulation of 
Accounting Policy 



A. Policy Formulation for Specific Types of Transactions 
RECOGNITION OF REVENUE 



CASE 16 



Trumpet 
Magazine 



i 



n July 1960, the management of Trumpet Magazine 
entered into a contract with a door-to-door sub- 
scription sales agency, thus acquiring a new source of circulation for the 
magazine and raising a new accounting problem for Mr. Donald Hughes, 
Trumpet's controller. Mr. Hughes had to decide how transactions under 
the contract should be treated; specifically, he had to choose one of three 
courses of action: (1) attempt to handle the transactions within the 
framework of the company's existing accounting policies regarding cir- 
culation income and expense, (2) recognize the unusual nature of the 
transactions and establish a separate policy for treating them, or (3) 
revise the company's present policies concerning circulation revenue and 
expense to permit a consistent treatment of both regular and new trans- 
actions under the revised policy. 

HISTORY OF TRUMPET MAGAZINE 

Trumpet was founded in 1882 by Mr. Nathaniel Franklin as a weekly 
.household magazine of broad literary and topical value. From the begin- 

103 



104 Trumpet Magazine 

ning, Trumpet published signed articles and high-quality short fiction, a 
combination which suited the magazine to a wide audience. Circulation 
had grown rapidly, reaching a peak of 800,000 copies per week just 
prior to World War I. After the war, and the untimely death of Mr. 
Franklin, Trumpet's editorial quality deteriorated rapidly. Although the 
magazine continued to survive, by 1946 circulation was only 250,000. 
At that time, a large minority interest in the company was purchased by 
Mr. Augustus Greene. Under Mr. Greene's aggressive editorship, Trumpet 
was rejuvenated and circulation began to climb, setting a new record 
of more than one million copies per week in 1959. In Mr. Hughes' opinion, 
the success of Trumpet since World War II indicated the paramount 
importance of editorial content to the success of a magazine. 

Looking at the industry from a business point-of-view, Mr. Hughes 
compared magazine publishing to a three-legged stool, one leg represent- 
ing each of the functions of editorial content, advertising, and circulation. 
No magazine could be a commercial success without good management 
in each one of these functions, all three of which, in Mr. Hughes' judg- 
ment, were interdependent. Advertising provided the primary source of 
revenue of the enterprise, but advertising rates and volume were depend- 
ent on the quantity and quality of the circulation (readership) of the 
magazine. Circulation, in turn, could not be achieved without attractive 
editorial content, and most of the cost of purchasing high-quality articles 
and stories for the magazine had to be paid for out of the advertising 
revenues. As Mr. Hughes said, "It's a complicated business, but a fascinat- 
ing and challenging one." 

Trumpet's circulation of slightly more than one million copies a week 
in 1960 was composed of newsstand sales of approximately 100,000 copies 
and deliveries to subscribers of over 900,000 copies. Trumpet was priced 
at $.20 per copy on the newsstand, and regular subscription prices were 
$6.50 for one year (52 issues), $12.00 for two years, and $15.00 for 
three years. Mr. Hughes pointed out, referring to Exhibit 1, that "news- 
stand sales are more profitable for Trumpet because the $.08 per copy 
we receive does not have to bear any other circulation expenses. Although 
we receive more revenue per copy on our regular subscription rates, we 
have to spend large sums of money convincing people to subscribe. Un- 
fortunately, we don't know any way to increase the volume of newsstand 
sales, so nearly all our efforts to increase the volume of circulation are 
directed at expanding the number of subscribers." 

The primary promotion device used by Trumpet to acquire new sub- 
scribers was to offer a six-month trial subscription (26 issues) for $1.69. 
The purpose of this half-price offer was to acquaint new readers with 
the editorial content of the magazine in the hope that they would get 
the "Trumpet habit" and would renew their subscriptions at the regular 
subscription rates. During 1960, 1,200,000 such trial subscriptions were 



Trumpet Magazine 105 

sold, providing the magazine with 600,000 "subscription-years" (one 
copy to a subscriber during each week of the year) of circulation. The 
remaining 300,000 subscription-years delivered during 1960 were to regu- 
lar (renewal) subscribers. 

During the early 1950's, Trumpet's circulation department had oper- 
ated at a substantial "profit," defined as the difference between circula- 
tion income and circulation expenses. This definition of profit was used 
only for management purposes, because a true accounting profit also had 
to include the much larger revenue from advertising and the heavy ex- 
penses of editing, printing, and distributing the magazine. Nevertheless, 
Trumpet's management thought that "circulation profit" was one measure 
of the health of the industry in general and Trumpet in particular. If 
the cost of acquiring subscriptions was greater than the revenue from 
subscriptions, this signified to Trumpet's management that either (1) 
they had gone beyond the natural market for their magazine and were 
attempting to "force" the increases in circulation, and/or (2) increasing 
competition in the industry was making profitable operations more dif- 
ficult. 

The easiest way to insure a circulation profit was to minimize ex- 
penditures for circulation promotion and to eliminate cut-rate trial 
subscriptions. Theoretically, if the magazine were attractive enough edi- 
torially, it would sell itself and almost all the subscription revenue would 
be pure profit. The disadvantage of this theory was that circulation might 
be relatively small and, although "profitable" for the circulation depart- 
ment, advertising revenues would be much smaller than would other- 
wise be possible. For example, Mr. Edwards, Trumpet's circulation man- 
ager, estimated that the magazine could probably maintain 400,000 
subscription-years of circulation without spending any significant amount 
on promotion. If this were done, the circulation profit would be well 
over $2,000,000 a year (400,000 subscriptions at a $6.00 average price, 
less some expenses), compared to the 1960 results of only $425,000 of 
circulation profit. Mr. Edwards pointed out, however, that at half the 
current level of circulation, Trumpet's advertising revenues would de- 
cline by $12,000,000. Printing and distributing costs would be less at a 
lower volume, but not in direct proportion; and therefore it was more 
profitable for Trumpet to operate with a small circulation profit than 
with a large one at a lower volume. In fact, Mr. Edwards said, many 
magazines were willing to incur large circulation losses in order to secure 
the revenues from higher advertising rates. 

Trumpet's circulation profits had been declining steadily since 1956, 
although the total operating profit reported by the magazine had in- 
creased each year. In fiscal year 1960, Trumpet's expenses for securing 
subscriptions were at a record high level of over $3,400,000 and were 
broken down by Mr. Edwards as follows. 



106 Trumpet Magazine 

Circulation Expenses, Fiscal Year 1960 

Number Sold Cost 
Cost of securing new trial subscribers 

Inserts in newsstand copies of Trumpet 50,000 $ 6,000 

Radio and TV advertising 110,000 137,000 

Inserts in other magazines 85,000 143,000 

Direct mail solicitation 955,000 2,643,000 

Total new subscriptions 1,200,000 $2,929,000 

Cost of soliciting renewals from trial and regular sub- 
scribers 268,000 

Salaries of creative and administrative staff of circula- 
tion department and other expenses 214,000 

Total $3,411,000 

Commenting on activities in 1960, Mr. Edwards said, "The pressure 
in the circulation department can be pretty intense sometimes. Once the 
board of directors has set our circulation guarantee (a promise to ad- 
vertisers that a certain number of copies of each issue would be sold), 
it's up to my department to see to it that the guarantee is met. We're 
currently guaranteeing 1,000,000 copies, and in order to deliver these 
during 1960 I had to sell 1,200,000 trial subscriptions. On my regular 
subscriber list, I have found that about 50 per cent of the subscribers 
will renew, so each year I have to replace half of my regular subscribers 
with new regulars. This means that I need about 12% per cent of the 
trial subscribers to renew. The cost of getting a new trial subscriber 
runs pretty high sometimes— some of my direct mailings cost me $3.00 
for each $1.69 subscription sold. Of course, you make it up when you 
sell the renewals. It only costs about $.20 to send our series of renewal 
letters, and any sales that result are at regular subscription prices. There- 
fore, we can afford to pay $2.00 or more to sell the initial trial subscrip- 
tion because from 10 per cent to 20 per cent of such sales will result in 
one renewal and, after one renewal, there is a 50 per cent chance that 
the subscriber will continue to renew year after year." 



THE DOOR-TO-DOOR AGENCY CONTRACT 

In the spring of 1960, Mr. Edwards had become concerned about 
the rising cost of selling trial subscriptions by mail. This method of sell- 
ing was expensive because only a small percentage of people receiving 
the mailing would enter a subscription. The cost of a mailing, depend- 
ing upon the type of literature and class of postage used, varied from 
$.05 to $.07 per piece. The percentage response, depending upon the 
effectiveness of the literature and the quality of the mailing list, varied 
from .5 per cent to as high as 3 per cent. On each major mailing list 
used, Mr. Edwards computed the "cost per subscription sold," and this 
cost varied from about $1.70 to $4.00. Mr. Edwards said, "As soon as we 



Trumpet Magazine 107 

have to start using such poor mailing lists that our cost climbs above 
$2.50, we need to look around for another way to sell subscriptions." 

In May 1960, Mr. Edwards was contacted by Mr. Douglas Greer, 
President of Nationwide Distributors, Inc., a company specializing in the 
sale of magazine subscriptions by door-to-door salesmen. Mr. Greer of- 
fered to add Trumpet to the list of magazines sold by his company and 
said that he thought his organization could sell 50,000 three-year sub- 
scriptions during each twelve-month period. Mr. Greer said that door- 
to-door selling was very expensive and, therefore, he wished to offer 
only a three-year subscription, thus raising the unit value of each sale. 
Mr. Greer wanted to offer the three-year subscription at the slightly 
reduced price of $12.50, but he also insisted that his heavy expenses 
made it necessary for his company to receive a commission of $13.00 
on each sale. In effect, the way the arrangement would work would be 
that Nationwide would assume all responsibility for collecting from the 
subscriber and would keep the proceeds it collected. In addition, as each 
new name was added to the subscriber role, Trumpet would pay Nation- 
wide $.50. Mr. Greer stated that this method of distribution would be 
cheaper for Trumpet than using poor-quality mailing lists, and that 
Trumpet would reap additional profits from the renewals that might be 
sold to these new customers at the end of three years. 

After considering the offer, exploring other alternatives, and discussing 
it with other members of Trumpet's management, Mr. Edwards signed a 
contract with Mr. Greer incorporating the terms described above. 



TRUMPETS ACCOUNTING POLICIES 

Trumpet's accounting policy in 1960 regarding circulation revenue and 
expense was simply stated: subscription revenue was recorded as deferred 
income when received and recognized as current income when copies 
were delivered to the subscriber; all expenses in the circulation depart- 
ment were charged off against current income. Mr. Hughes explained that 
this policy had been adopted for several reasons. First, such a treatment 
was permissible for income tax purposes (although other reasonable and 
consistent methods were also allowed) and had the advantage of post- 
poning the recognition of taxable income. Second, the method was con- 
servative in that it did not anticipate future profits but did recognize all 
expenses. And finally, although it could be argued that the cost of ac- 
quiring a new trial subscription should be deferred as an expense of the 
life of the subscription, these subscriptions ran for only six months, and 
consequently the amount that would have been deferred would have 
been small and the period of deferral would have been short. 

The new door-to-door agency contract could be handled within the 



108 Trumpet Magazine 

existing policy, but Mr. Hughes was concerned that it would have a 
seriously unfavorable impact on earnings during the first year. If 50,000 
subscriptions were sold, the total commission would amount to $650,000. 
For income tax purposes, Mr. Hughes did not plan to change his ac- 
counting procedure, since this large expense in the first year would merely 
reduce the company's current tax payments. It would be possible, how- 
ever, to use different methods for tax and for corporate reporting pur- 
poses. 

While considering what change, if any, to make in the policy for 
circulation revenue and expense, Mr. Hughes wondered if perhaps an 
even more drastic change should be examined. He remembered a con- 
versation with Mr. Greene, the president, in which Mr. Greene had said, 
"I think you accountants are really blind to the economic facts of life 
sometimes. Look at the balance sheet that you prepare for the public 
(see Exhibit 1). According to you, our biggest liability is for 'unearned 
subscription revenue/ In my opinion that is no liability— actually it is 
our biggest asset. It represents over a half-year of circulation and, be- 
cause of that circulation our advertisers will pay us twelve or fifteen 
million dollars. And many of those subscribers will renew, thus generat- 
ing more advertising dollars. Why, I wouldn't sell our subscriber lists 
for $5 million— and neither would you." 

Required 

1. What policy should Trumpet Magazine follow in accounting for circulation 
revenues and expenses? If you believe a change in policy is desirable, 
compute the approximate effect it would have on reported income for fiscal 
year 1960. 

2. Assume that fiscal year 1961 will produce the same operating results as 
1960, except that 100,000 six-month trial subscriptions will not be sold 
(thus reducing the costs of direct mail solicitation by $300,000) because 
50,000 three-year subscriptions will be sold by the door-to-door agency. 
Prepare pro forma financial statements for 1961 to reflect the effect of the 
several alternative accounting policies you believe Mr. Hughes should 
consider. (Remember that the procedure for computing taxable income 
will not be changed.) 



EXHIBIT 1 



Condensed Financial Statements 
Income Statement for Year Ended June 30, 1960 



Income from: Advertising $24,416,732 

Subscriptions 3,837,411 

Newsstand sales and miscellaneous 408,116 

Total income $28,662,259 

Expenses: Costs of editing, printing, and distributing the 

magazine $17,480,274 

Cost of securing advertisements 1,638,127 

Cost of securing subscriptions 3,411,421 

Administrative and general expenses 2,848,763 

Total expenses $25,378,585 

Operating profit $ 3,283,674 

Federal income taxes 1,702,391 

Net profit, after taxes $ 1,581,283 



Balance Sheet at June 30, 1960 

Assets 

Cash $3,041,461 

Receivables 2,671,804 

Inventories: Drawings and manuscripts 975,418 

Paper, stationery, and supplies . . 1,518,311 

Total current assets $8,206,994 

Furniture, fixtures, and autos (net) 318,407 

Other assets 148,609 

Total assets $8,674,010 



Liabilities and Capital 

Accounts payable $2,017,397 

Taxes payable 942,718 

Total current liabilities .... $3,060,115 

Unearned subscription revenue 2,117,932 

Capital stock 400,000 

Earned surplus 3,095,963 

Total liabilities and capital . . $8,674,010 



109 



v\ 



CASE 17 



Industrial 
Factors, Inc. 



i 



n January 1960, Mr. Richard J. Morrison, treasurer 
of Industrial Factors, Inc., had just completed his 
review of the corporation's 1959 financial accounts (Exhibits 1 and 2). 
He was particularly pleased with the 1959 results; apart from the ex- 
pected increase in gross income through the corporation's normal growth, 
1959 was a considerably better year than 1958 because the expense 
"Provision for Losses" (equivalent to Bad Debt Expense) had been 
reduced from $657,000 in 1958 to $17,000 in 1959. This reduction had 
materially boosted net profits. 

Mr. Morrison was concerned, however. He suspected that the nation's 
economy was due to take a downturn in 1960. If it did, then the cor- 
poration might once again have to absorb an abnormally high Provision 
for Losses, so that it would be difficult for the 1959 profit level to be 
maintained. Mr. Morrison felt that, because of this tendency to fluctuate, 
"profits," as reported in the corporation's annual financial statements, 
was not an accurate or meaningful figure. The Provision for Losses ac- 
count, which was largely the cause of fluctuations in reported profits, was 
built up annually in accordance with set policies. Mr. Morrison wondered 
whether the corporation's present policy as it applied to providing for 
bad debt losses should not be reviewed and perhaps overhauled. If he 
found that the accounting policies currently used produced a distorted 
result he would strongly favor adoption of a new policy designed to 

110 



Industrial Factors, Inc. Ill 

provide a more meaningful measure of losses incurred and the net income 
remaining thereafter. 



HISTORY 

Industrial Factors, Inc., was founded in New York at the turn of the 
century. Its history and growth since that time were typical of the whole 
factoring industry. 

Old-line factors, as they were called, developed primarily as service 
organizations for overseas and local textile manufacturers. They pro- 
vided sales representation, storage and display facilities, delivery services, 
and usually assumed the risk of credit losses. At the time that Industrial 
Factors commenced business, however, the nature of factoring was 
undergoing a substantial change. The financial and advisory services that 
factoring firms provided were growing in importance, but client firms 
typically found that their own growth enabled them to perform the 
various merchandising functions better themselves. With the greater 
emphasis on financial services, factoring firms began to serve clients in 
many other branches of manufacturing industry, although textile con- 
cerns remained the backbone of their business. 

PRESENT-DAY FACTORING 

The services offered by Industrial Factors were not significantly dif- 
ferent from those offered by other factors. Essentially, a factoring agree- 
ment was a continuous arrangement whereby the factor purchased, for 
cash, all a client's accounts receivable ( from trade buyers ) , as and when 
they were created by shipments by the client. The price paid was de- 
termined by deducting the following from the face value of the client's 
invoice to his customer: 

1. Any trade discounts allowed. 

2. Discounting charges (equivalent to interest) calculated from the 
date that the invoice was purchased to its maturity date ( date due ) . 
The rate charged was traditionally 6 per cent, but had been higher 
in recent years. Current practice was to gear it to the prime bank 
rate. Where clients did not withdraw the monies credited to them, 
Industrial Factors allowed interest thereon until the maturity date 
of the various invoices, so that interest could be earned, at maximum, 
to offset the amount charged. Since the total interest charged to 
clients was calculated on a time basis, it was Industrial Factors' 
practice, at each financial statement date, to adjust the total credited 
to the Interest Received account by deferring until the following 
period that portion of the interest that related to that period. 



112 Industrial Factors, Inc. 

3. Factors' commission might range from 0.75 per cent to 1.75 per 
cent. The fee charged each client was fixed by arrangement, and 
varied between different clients according to the nature of the 
client's industry, his annual sales volume, his average dollar sale 
and number of customers, and the latter's average credit standing 
and terms of sale allowed. 

In purchasing the accounts receivable, the factor stood to lose his 
money if the account were not paid. For this reason, shipments to the 
client's customers had to be approved first by the factor's credit officers. 
The client was, in consequence, relieved of the necessity of maintaining 
his own credit department. 

A typical factoring arrangement specified that the client's customers 
were required to make their payments directly to the factor. Conse- 
quently, it was the factor who maintained the accounting records relating 
to the accounts receivable, and instituted collection procedures on delin- 
quent accounts, again relieving his client of a burden. 

All factoring companies claimed that there were several advantages 
in the factoring "package" they offered to their clients. They pointed out 
that there was no other single source of the many financial, credit, and 
accounting services that they offered. Furthermore, they offered these 
services against payment of a known cost. 

As an illustration of the close relationship that existed between factor- 
ing companies and many of their clients, both in regard to services of- 
fered by the factors and in regard to banking and financial arrange- 
ments, it was a common experience that factoring relationships were 
maintained even when client companies did not have the need to dis- 
count all their receivables. The factoring companies would not permit 
their clients to discount selectively, although they would agree to ar- 
rangements to factor only those receivables arising out of a particular 
segment of a client's business. It could therefore happen that clients 
would not immediately draw out the full amount credited to them for 
receivables factored, if they did not need all the money at one time. 
As factoring companies customarily allowed offsetting interest on clients' 
credit balances up to the amount originally charged for interest, their 
clients, in effect, paid interest on only the actual amount of money made 
available and used. These clients' credit balances often amounted to 
large sums of money; the factors regarded these large sums as an indica- 
tion of the confidence that their clients placed in them. 



MECHANICS ON PROVISION FOR LOSSES 

Technically speaking, the books of Industrial Factors contained two 
ledger accounts around which the bad debt problem focused. The first 



Industrial Factors, Inc. 113 

was a reserve account titled "Reserve for Losses." This account was 
reflected as a valuation reserve in the corporations balance sheets; that 
is to say, it was shown as a deduction from the gross amount of Accounts 
Receivable. 1 The Reserve for Losses was traditionally maintained at 0.85 
per cent of trade accounts receivable, and was therefore adjusted at the 
end of each month when financial statements were prepared. The per- 
centage used dated back for many, many years. It represented a con- 
servative judgment, in effect, that at any date, trade accounts in total 
were worth a minimum of 99.15 per cent of face value. 

The normal procedure whenever a bad debt loss was recognized 
( detailed below ) was that the amount involved would be debited against 
the Reserve for Losses. This was in line with the proposition that the 
reserve represented a "pool" held to cover any losses. Accordingly, it 
also became necessary, whenever financial accounts were drawn up, that 
the reserve be reinstated in the amount by which it had been depleted 
through recognition of losses. 

The second ledger account that was used was titled "Provision for 
Losses." This was the account that was debited whenever any entry 
was made to add to (or credit) the Reserve for Losses. The Provision 
for Losses account was therefore an expense account and was reflected 
as an expense in the corporation's income statements. Under the setup 
used by Industrial Factors, any amount added to the Reserve for Losses 
did in fact represent a bad debt expense in the way that term was 
defined. This was why the Provision for Losses, which "fed" the Reserve 
for Losses, was treated as an expense account. 

POLICY ON RECOGNITION OF LOSSES 

As has been previously stated, the Reserve for Losses was adjusted 
from time to time to bring it up to 0.85 per cent of trade accounts re- 
ceivable. Generally speaking, the adjustment was an addition to the 
reserve, since Industrial Factors' annual volume was increasing (Exhibit 
5). This addition to the reserve, fed through the Provision for Losses, 
was regarded as an expense because of the stated assumption that a 
valuation reserve of 0.85 per cent was proper and correct. 

To some degree, other charges to the Provision for Losses account 
were more directly related to actual losses. Of the two major loss cate- 
gories, one was delinquent accounts. Such accounts were charged to 
the reserve and physically separated from the accounts receivable ledger. 



1 In actual fact, Industrial Factors kept separate reserve accounts for trade ac- 
counts receivable purchased in the ordinary course of business, and for loans which 
it made directly to clients. The latter reserve constituted only a small part of the 
total, and we are not concerned with it or its operation in this case. 



114 Industrial Factors, Inc. 

The criterion used in determining delinquent accounts could be any 
one of the following: 

(a) Receivable became ten months old; 

(b) Creditors' meeting held consequent to financial difficulties; 

(c) Voluntary or involuntary petition filed in bankruptcy; 

(d) Any other good and sufficient reason became apparent. 

By Industrial Factors' past experience, any one of these criteria was suf- 
ficient to classify an account as a "bad debt." The procedure followed 
was to charge off the full amount immediately. Any later recoveries 
were netted against the amounts written off. No estimates were made 
of the recoverable portion of any delinquent account; it was presumed 
that the account was completely worthless until any recovery was re- 
ceived. This policy was followed rigorously; no recognition was given to 
any special circumstances that might make a particular account wholly 
or partly recoverable if it "qualified" as delinquent under any of the 
specific criteria listed. A summary of the past five years' figures for 
these write-offs (known as Credit Department write-offs) is given in 
Exhibit 4. 

Beginning in 1957, a refinement had been introduced into the account- 
ing procedure used to record the other major loss category, "slow-pay" 
accounts (accounts more than six months past due). Any account that 
became overdue to this extent was regarded as a potential loss. Up to 
1957 these write-offs had been included with Credit Department write- 
offs; at that time, however, it was decided to record slow-pay write-offs 
separately, in order to provide more useful data on write-off categories. 
Therefore, beginning in 1957, it became the policy to make a separate 
charge to the Reserve for Losses for all accounts which qualified as slow 
payers. As with delinquent accounts, no estimates were made of likeli- 
hood of recovery of any or all of the amount involved. The six-month 
rule was enforced rigorously. 

In actual practice, the prospect of full or even partial recovery was 
much greater on a slow-pay account than it was on a delinquent account 
(this was one reason for the differentiation). In fact, it was the cor- 
poration's experience that a large proportion of the slow-pay write-offs 
was recovered. Any recovery was, of course, recorded in the books by 
a reversal of the write-off entry, irrespective of the nature of the original 
write-off. 

It will be apparent that there have been only two end results after 
a slow-pay write-off; the account would have been paid, or it would have 
become delinquent according to the criteria described above. In the 
latter event, the write-off was processed in exactly the manner described 
previously, without regard to the fact that the account had previously 
been written off as a slow-pay account. In this case, however, an adjust- 



Industrial Factors, Inc. 115 

ment would be made by reversing the original slow-pay write-off, that 
is, crediting the Reserve for Losses and debiting Trade Accounts Re- 
ceivable. (A five-year detailed summary of the Provision for Losses ac- 
count is given in Exhibit 3.) 



OTHER POLICY CONSIDERATIONS 

In his review of the policy implications of the write-off procedure 
already described, Mr. Morrison noted the following general consid- 
erations : 

(a) Because the policy was both consistent from year to year, and 
followed one of the provisions of the Internal Revenue Code, the full 
amount debited as Provision for Losses each year was allowed for income 
tax purposes. 

(b) Industrial Factors had been in existence for many years, and, 
perhaps to a greater extent than many other, newer firms, enjoyed a very 
strong reputation, both with its clients and in the financial world. As 
a long-established company, many of its procedures, including its ac- 
counting policies, were deliberately on the conservative side. The cor- 
poration's management felt that its conservative reputation was important 
and ought to be preserved. It was of considerable significance in the 
total "image" of Industrial Factors, Inc. 

POLICY REVIEW 

Mr. Morrison was not sure just what he ought to do about Industrial 
Factors' policy on providing for losses on accounts receivable. Accord- 
ingly, he solicitated some opinions from other executives of the cor- 
poration. 

Mr. Eliot Falk, the head of the Credit Department, did not seem to be 
much concerned with Mr. Morrison's problem. He pointed out that the 
accounting for income and expense done by the controller's office did not 
affect his department in the least. He ran his department according to 
his own ideas. For example, he required credit officers to submit a report 
to him giving full details on all accounts subjected to write-off. This re- 
port included an estimate by the officer in question on the recoverability 
of the amount written off. However, Mr. Falk did not feel that these 
estimates were at all valid, or that they could be used in accounting for 
estimated losses. He felt that it was impossible, even for his credit ex- 
perts, to make any kind of reasonable or realistic estimate of recover- 
ability. When asked about it, he confirmed his present practice of not 
maintaining any record, under the names of the various credit officers, 
of the bad debts charged off by each. He assured Mr. Morrison that the 



116 Industrial Factors, Inc. 

credit officers felt no unwillingness to write off any account, and that they 
abided very strictly to the corporation's rules on the subject. 

A suggestion was made by Mr. Tony Martley, one of Mr. Morrisons 
assistants. His idea was that the annual credit of the Reserves for Losses 
be fixed at, for example, one-eighth of 1 per cent of annual volume ( sta- 
tistics quoted in Exhibit 5). He felt that since bad debt expense was, 
perhaps, a normal or regular expense, it should be charged against in- 
come in some proportion to income, such as annual volume. This would 
make the expense charge something like an insurance premium. As he 
envisaged it, the fixed percentage would be credited to the Reserve for 
Losses each year. All bad debts, however defined, would be charged 
against the reserve as before. The balance remaining in the reserve ac- 
count from time to time would simply represent an estimate of the losses 
yet to be incurred on the existing account receivable. Mr. Martley pointed 
out that this system would do away with the fixed 0.85 per cent reserve 
at each statement date. Furthermore, he calculated that, had his system 
been started in 1955 and continued through 1959, the total amount 
charged as expense in the five years would have been $1,677,500 as 
against an actual $1,748,000 charged off through the Provision for Losses 
over that period. This, he said, indicated that his suggested percentage 
was an accurate measure of the average expense ratio. 

Mr. Morrison thought that the idea suggested by Mr. Martley might 
have some merit, but he was not quite sure if the principle was sound. 
He felt, however, that Mr. Martley's proposal neglected what might well 
be the major problem inherent in the present policy, namely, the rigorous 
application of the principle of write-off. Admittedly, this would be a 
conservative policy, but might it be too conservative? Did it result in a 
distortion of reported income? For example, Mr. Morrison called to mind 
the situation caused by an abnormally large slow-pay account that was 
written off near the end of the 1958 financial year. A full write-off had 
been recorded on an account of nearly $150,000 that had fallen more 
than six months past due. As it turned out, payment was received in full 
early in 1959, but after the 1958 financial accounts had been prepared. 
This, plus an abnormally high rate of recovery on Other slow-pay ac- 
counts, had produced the abnormal credit figure on net slow-pay write- 
offs in 1959 (Exhibit 3), contrasting with the extra large debit the 
previous year. Surely, Mr. Morrison thought, something ought to be 
done to prevent such a situation arising again. He noted wryly that had 
the write-off and recovery both occurred within the same financial year, 
there would have been none of the unfortunate distortion that arose. 



Industrial Factors, Inc. 117 



Required 

1. Prepare the journal entries required to record all transactions on the 
Reserve for Losses and Provision for Losses accounts for 1958 and 1959. 

2. What were the year-end balances of trade accounts receivable each year 
from 1955 through 1958? 

3. Calculate the effect on net income, had Mr. Morrison been able to forecast 
with a high degree of accuracy the following year's recoveries of each year's 
credit department write-offs from 1955 to 1958. 

4. Should Industrial Factors maintain its present write-off policies? If not, 
what policies would you recommend be adopted? 

5. Would you, as Mr. Morrison, recommend any change in the principle of a 
balance sheet "valuation reserve" of 0.85 per cent of accounts receivable? 
What function does such a reserve serve? Is there any merit in the concept 
of a reserve determined as this one was determined? 



EXHIBIT 1 



Balance Sheet at December 31, 1959 



Current assets: 

Cash $ 2,573,000 

Accounts receivable and loans 

Trade accounts $37,336,000 

Advances to clients 8,364,000 

$45,700,000 

Less reserves for losses 384,000 45,316,000 

Total current assets $47,889,000 

Deferred charges and prepayments 7,000 

$47,897,000 

Current liabilities: 

Accounts payable $ 2,473,000 

Federal income taxes 453,000 

Clients' credit balances 23,012,000 

Notes payable to bank 5,815,000 

Total current liabilities $31,753,000 

Long-term debt 6,000,000 

Deferred income 275,000 

Capital stock and surplus 

Common stock, $10 par $ 2,000,000 

Paid-in surplus 2,500,000 

Earned surplus 5,369,000 

9,869,0 00 



$47,897,000 



EXHIBIT 2 



Income Statement* for the Year Ended 

December 31, 1959 

($000) 

Commission $3,200 

Interest received 2,400 

Gross income $5,600 

Salaries $1,040 

Other operating expenses 670 

Interest paid 1,123 

Provision for losses 17 

Total expenses $2,850 



Net income, before taxes $2,750 

Federal and State income taxes 1,540 

Net income, after taxes $1,210 

*The actual expense detail shown above was supplied by Industrial Factors, 
Inc., for the purpose of showing the relative importance of different headings. In 
its published financial statements the corporation gave no expense details other 
than "interest paid" and "all other expenses." 



118 



EXHIBIT 3 



Analysis of "Provision for Losses 
Account) 1955 to 1959 
($000) 



(Expense 



1959 1958 1957 1956 1955 

Slow-pay* $(231) $198 $ 37 $ f $ f 

Credit department} 229 287 323 185 81 

Year-end§ 26 5 11 62 9 

Loan write-offs (7) 167 198 86 82 

$ 17 $657 $569 $333 $172 

*Net amount credited or (debited) to Reserve for Losses, to make good 
amounts charged to the Reserve for slow-pay accounts. 

f Included in "Credit Department" through 1956— not available as a separate 
item. 

| Net Credit Department write-offs for the year; see Exhibit 4. 

§ Amount required to bring Reserve for Losses up to 0.85% of year- end total 
of Trade Accounts Receivable. 



EXHIBIT 4 



Analysis of Net Credit Department Write-offs, 

1955 to 1959 

($000) 

1959 1958 1957 1956 1955 



Write-offs $374 $432 $427 $276 $209 

Recoveries 

Current year $ 88 $ 78 $ 6 $ 37 n.a. 

Previous year 43 54 80 46 n.a. 

Prior years 14 



Net write-offs $229 



13 


18 


8 


n.a. 


$145 


$104 


$ 91 


$128 


$287 


$323 


$185 


$ 81 



EXHIBIT 5 



Annual Volume, 1955 to 1959* 



1959 $327,000,000 

1958 274,000,000 

1957 271,000,000 

1956 256,000,000 

1955 214,000,000 

♦As the words are used in the factoring business, ' 'Annual Volume" means 
the face amount of trade receivables acquired. 



119 



CASE 18 



Charles Crowne 
Company 



A' 



a meeting on January 16, 1958, of the three 
officers of the Charles Crowne Company, a gen- 
eral construction firm located in a large Midwestern city, Mr. John 
Crowne, vice president and treasurer, raised a question concerning the 
method the company should use in recording profits on its construction 
contracts. He remarked that during a recent conversation he had been 
told by the treasurer and office manager of a building supply firm that 
a construction company could report its profits either on a percentage-of- 
dollar-completion or on a job-completion basis and that each method 
could have a material effect on a company's net income and financial 
statements. John Crowne's statement puzzled the other two officers who 
asked for a detailed explanation of the alternatives. In reply, John 
Crowne stated that he could not explain the percentage method or its 
significance, because time pressure had prevented him from questioning 
his friend about the methods. He added that he was certain that the 
company was currently following the job-completion method of record- 
ing profit or loss on contracts only at the completion of the contracts. 

John noted that the company's financial statements were furnished to 
architects and bonding companies, who used them as a means of apprais- 
ing a contractor's ability to perform a contract he was bidding on. In 
view of the way in which the statements were used, all officers agreed 
they should be aware of the available alternatives because the use of 
various methods might influence the company's success in obtaining con- 

120 



Charles Crowne Company 121 

tracts from architects and gaining coverage from bonding companies. 

The officers became concerned with the tax accounting aspects of 
available alternatives and also wondered whether different methods 
could be used for tax and financial accounting purposes. Another factor 
mentioned was the future prosperity of the Charles Crowne Company 
and the construction industry in general. Although over the long run 
the officers expected to expand the volume of company business, the 
prospects for 1958 did not appear too favorable. As a final consideration, 
John Crowne noted that the company would soon have to furnish finan- 
cial statements with its request to the Second National Bank for financial 
assistance for a proposed office and storage building that would be con- 
structed in the spring of the current year. John wondered whether the 
company's bank credit standing would be influenced by a change in 
accounting methods. 

At the conclusion of the meeting, John Crowne agreed to question his 
friend about the available alternatives in detail, to review their applica- 
tion to the Charles Crowne Company, and then to submit his recommen- 
dation to the other two officers. 

COMPANY BACKGROUND 

In 1926, Mr. Charles Crowne founded his own masonry contracting 
firm as a single proprietorship employing a crew of five men. Although 
the firm grew slowly up to 1951, Mr. Crowne had restricted the company's 
operations to the masonry business. In 1951, Mr. Crowne's son John 
joined the firm after obtaining a degree in architectural engineering. 
Shortly thereafter, the company started a gradual move into the general 
construction field. By 1956, the firm was engaged almost entirely as a 
general contractor, devoting its major effort to institutional projects such 
as garages, churches, and fire stations. 

In bidding on projects as a general contractor, the Charles Crowne 
Company usually compiled estimates of the cost to complete a project, 
adding to these costs a percentage for overhead and profit. A large part 
of the estimates would be based on the bids of subcontractors for special 
portions of a job. The general contractor would then compile the total 
estimate for the project and submit a bid. If the contract was obtained, 
the contractor would then award subcontracts to those subcontractors 
who had submitted the lowest bid for portions of the project. The con- 
tracts received were almost always of a fixed-price nature. 

On January 1, 1957, the company was incorporated with Mr. Charles 
Crowne, president, holding 60 per cent of the common stock; John 
Crowne, vice president and treasurer, holding 30 per cent; and Larry 
Shane, who was not related to the Crownes, owning 10 per cent and hold- 
ing the position of secretary and office manager. 



122 Charles Crowne Company 

Although the company acted as general contractor on all projects in 
which it was engaged, it continued to perform all masonry work on its 
contracts. In addition, the company employed a force of carpenters on 
company jobs to handle all rough carpentry work and also to assist in 
supervision of company-employed laborers and the subcontractors. Most 
work on company projects was performed by subcontractors. 

Mr. Charles Crowne frequently acted as the general superintendent on 
the most important company jobs, while John Crowne traveled between 
all other job sites to carry out general supervision and to check on work 
progress and performance. Mr. Shane handled all office work, including 
the compilation of estimates and proposals for new contracts. Each 
evening the officers met to discuss the status of jobs and future plans of 
the company. 



RESULTS OF 1957 

Because of the high volume of institutional construction activity, 1957 
was a record year for the Charles Crowne Company. The sales value of 
contracts completed in 1957, according to preliminary figures, was 
$1,143,303.06, as compared with the previous high in 1953 of $819,348.76. 
Net profit before taxes and officers' compensation in 1957 was estimated 
at $106,113.74; on a comparable basis $62,809.12 had been earned in 
1956 (see Exhibits 1, 2, 3, 5). 

The status report of contracts in process (see Exhibit 6) as of De- 
cember 31, 1957, showed that three contracts having a total value of 
$464,464 were in various stages of completion. A total cost of $190,816.52 
had been incurred to date on these contracts. Of these three contracts, 
two were for fire stations and one for a municipal garage. All three of 
these contracts had been started after August 1957 and were estimated 
to be completed in the spring or early summer of 1958. No revenue or 
costs on these contracts had been recorded in the income statement for 
1957. 

OUTLOOK FOR 1958 

The officers of the company felt that the construction outlook for their 
area was not too bright. Over-all construction activity seemed likely to be 
high, but the officers believed that profit margins would fall. Increasing 
competition in the field of institutional construction was expected be- 
cause a downturn in residential building was forcing residential con- 
tractors into the institutional field. As a result, the company had lowered 
its provision for general overhead and profit in recent bids for new con- 
tracts to approximately 10 per cent of the contract sales value. In the 



Charles Crowne Company 123 

past, it had been company practice to include a profit of 10 per cent 
plus a provision for general and administrative overhead of 5 per cent 
in its proposals. Although the officers realized that it was possible that 
the company might register losses on one or more contracts as a result 
of bidding at a lower figure than normal, they felt that the losses, if in- 
curred, would be small; they hoped that, in the aggregate, volume would 
tend to wash out any individual loss and give the company a fair profit. 
Company records showed that where losses had been incurred on con- 
tracts in the past, they had never exceeded 11 per cent of the contract 
value. 

Company officers expected to submit bids in 1958 on projects that were 
similar in nature to projects in progress or recently completed. As of 
January 8, 1958, the company had no backlog of contracts on which it 
had not started work. Activity in the granting of contracts was usually 
low in January and February but customarily picked up in March. 

It was not the present intention of company officers to try to obtain 
contracts for projects having an individual value in excess of $400,000. 
There were several reasons for this policy. First was the fact that officers 
desired to spread risks over a number of contracts. Second was a con- 
sideration of keeping the company name before the architects in the area. 
Architects generally acted as agents for project owners and were usually 
responsible for examining the reliability of contractors who were bidding 
on a project. Contractors who were unknown or not considered reliable 
usually had their bids eliminated from further consideration. The officers 
of the company recalled that it had taken several years to acquaint archi- 
tects in their area with the company name and its ability to perform a 
job. If they committed the company to one or two large long-term con- 
tracts, the officers believed they would effectively remove the name of 
the company from the sight of architects for a considerable period of 
time. They were unwilling to do this because they felt that they would 
have difficulty in re-establishing the company with architects when the 
long-term contracts were completed. 

A third reason for not seeking contracts over $400,000 concerned the 
very important role of the bonding companies. Charles Crowne Company, 
like every other contractor, was usually required to post certain bonds 
with the architect (or the project owner); such bonds postulated that 
the company would complete the contract according to specifications. 
Frequently, a clause was included in contracts which specified that the 
contractor would pay a penalty if the project were not completed by a 
given date. Nonfulfillment of the stated provisions could result in the 
forfeiture of the bond and a consequent payment by the bonding com- 
pany in the stipulated amount of the coverage to the architect and project 
owner. In order to prevent contractors from overextending themselves, 
the bonding companies imposed a maximum limit on the contracts that 



124 Charles Crowne Company 

any contractor could have outstanding at any one time. The bonding 
companies would not provide a bond on a contract if, as a result of taking 
on this contract, the total sales value of outstanding contracts exceeded 
ten times the contractor's net worth. Thus, with the Charles Crowne 
Company's net worth as of December 31, 1957, of $123,080.52, total con- 
tracts of $1,230,800 could be handled at the present time. Therefore, 
by taking on contracts having a value over $400,000, the officers believed 
the company would be restricted in satisfying the first and second con- 
siderations outlined above. Even if the ratio should be suddenly in- 
creased, thereby allowing the company to expand its work, there would 
be further problems of obtaining a capable work force and acquiring 
the necessary equipment. 



ACCOUNTING PROCESS 

(a) Recording of Costs. The company's accounting system was not 
complex and was capable of being handled on a part-time basis by an 
outside accountant. This accountant worked two nights a week at the 
company offices updating the cost and general ledgers, the general 
journal, and handling other necessary accounting work. The accountant's 
main job was to keep accurate records of the costs incurred for each 
job or contract. Separate subledgers for each contract were kept to 
facilitate this work. 

As job costs were incurred by the company, they were posted or 
charged to the appropriate job or contract ledger after being recorded 
in the general journal. A voucher was also made out recording the sup- 
plier's or subcontractor's name and address along with the amount payable 
and filed as a liability. Charges for company- employed labor were re- 
corded at the job site and forwarded to the office, The recording speci- 
fied for each man the hours worked, his rate, and the nature of the work 
performed. These recordings, along with being posted to the appropriate 
jobs, were also used as the basis for computing payrolls. The total of the 
balances in the job ledger accounts was the company's "work in process." 

The job cost accounts tended to be the same for each job, with the 
following typically used major classifications: 

1. Subcontracts: Separate subaccounts were maintained for each sub- 
contract. For instance, on Job #220, a fire station under construction, 
there were over twenty subcontracts for various portions of the 
total job. A list of the subcontract accounts on Job #220 is provided 
in Exhibit 4. 

( The following accounts recorded company incurred job costs. ) 

2. Masonry: Separate job accounts were kept for company masonry 
labor and company-purchased masonry materials. 



Charles Crowne Company 125 

3. Carpentry: Same as for masonry. 

4. Special Projects: Separate project accounts were provided when un- 
usual portions of a contract were to be completed by the company. 
For instance, in completing Job #220, the company was to install 
the slide poles to be used in the fire station, and also erect a flag 
pole. Costs incurred for these purposes would be charged to special 
slide pole and flag pole accounts. 

5. Supervision: Used to record the supervisory costs for each job. 

6. Performance Bond and Insurance: Used to record the bonding 
charges and insurance required for each job. 

7. General Conditions: Separate account for each job; used to include 
all job costs not charged to other accounts. The account contained 
such items as the cost of the construction shack, telephone and other 
utilities, general office supplies, wages of timekeeper and watchman 
(if necessary), and the wages of laborers that could not be easily 
separated into other accounts. This account did not include any of 
the company's general and administrative expenses which were not 
allocated to the jobs. 

(b) Billing. On contracts in process, the Charles Crowne Company 
usually submitted a monthly "Application for Payment" to the architect 
who represented the project owner. Exhibit 7 shows the detail provided 
on the "application." The items marked with an asterisk are for company 
portions of the job, whereas the remainder are for subcontracted sections 
of the job. 

Several steps were involved in determining the amount billed by the 
contractor. First, an officer of the company estimated the physical per- 
centage of completion of each major portion of the contract. Thus, in the 
case of the masonry item on Exhibit 7, it was estimated that masonry 
work was 90 per cent complete at the end of the month. Because masonry 
had been estimated at 78 per cent of completion at the close of the prior 
month, then 12 per cent of the $51,200 value attached to masonry, or 
$6,120, was deemed to be the gross amount that should be billed for the 
current month. Noteworthy is the fact that costs incurred to date as a 
percentage of total estimated costs did not determine the percentage of 
completion. Thus, the gross billing of $6,120 for the current month could 
be either equal to, less than, or greater than the actual costs incurred 
in the month, plus the allowances for profit and overhead that were pre- 
dicted in bidding the job. 

As in the case of masonry, a similar estimating procedure was followed 
on the other items of the job. The items were then summed to obtain the 
gross billing for the current month. From this total gross billing an 
amount called "retainage," agreed to in the contract as 10 per cent of the 
gross billing, was deducted to obtain the net billing due the contractor. 



126 Charles Crowne Company 

The application was then forwarded to the architect who had the job of 
verifying the percentage of physical completion claimed by the con- 
tractor. If the architect considered the percentage billed as valid, he 
certified the application and requested on a separate form that the project 
owner forward the net billing to the contractor. The contractor usually 
received his progress payment within fifteen days after the date of billing. 

(c) Recording of Income. As mentioned above, the company used the 
completed-contract method in recording income from contracts. Under 
this system, the profit or loss on a contract was not booked until the con- 
tract was completed and accepted by the project owner. 

The company recorded the billings, net of retainage, with the following 
entry: 

dr. Accounts Receivable— Job #220 
cr. WIP- Job #220 

Using this method, the work in process account for Job #220 had a credit 
balance as of December 31, 1957, which represented billings (net of 
retainage) in excess of costs. 

When the contractor received payment, the following entry was made: 

dr. Cash 

cr. A/R-Job #220 

At the final billing of a contract, the company billed the owner for all 
retainage using the same entry as the first. 

dr. Accounts Receivable— Job #220 
cr. Work-In-Process- Job #220 

When the contract was complete, the credit balance in the work-in- 
process account was the profit on the contract. This amount was closed 
out to profit and loss as follows: 

dr. Work-In-Process- Job #220 
cr. Profit on- Job #220 



APPENDIX 

The Federal income tax regulations pertaining to the methods allow- 
able in determining contractor's profits are found in Treasury Regulation 
1.451-3, which states that a contract must be outstanding more than twelve 
months in order to qualify as a long-term contract. If the contract qualifies 
as to time length, then the contractor may employ either the percentage 
or completed-contract method, again provided he is consistent in his 
treatment. Thus, under the law, contracts of shorter duration than one 
year could not have their profits determined under either of these 
methods. However, there is wide precedent in court cases where the com- 



Charles Crowne Company 127 

pleted contract method has been employed on contracts lasting over a 
period considerably less than one year. Of course, the importance of this 
fact arises only in cases where more than one accounting period is in- 
volved. To date, no exception to the twelve-month period stated in the 
regulations exists for the percentage method. Several legal authorities 
have argued that contractors should be allowed to use the percentage 
method when a contract involves at least two accounting periods. 



EXHIBIT 1 



Income Statement for Year Ended December 31, 1957 



Sales value of completed contracts 

Cost of contracts completed 

Gross income from contracts 

Add: Discounts earned 

Less: 

General and administrative expense $21,909.88 

Officers compensation 69,140.00 

Net income before tax 

Federal taxes 

Net income 



$1,143,303.06 
1,026,112.10 
$ 117,190.96 
$ 10,832.66 
$ 128,023.62 



91,049.88 
$ 36,973.74 

13,893.22 
$ 23,080.52 



EXHIBIT 2 


Sales and Income— 1951-1956 

Gross Income from 
Sales Value of Contracts (includ- 
ontracts Completed ing Discounts Earned) 




Year C 


Profit Before* 
Officers Compen- 
sation and Tax 


1956 


$661,384.74 


$87,565.50 


$62,809.12 


1955 


340,381.42 


38,199.54 


24,589.42 


1954 


581,220.50 


49,487.42 


32,562.961 


1953 


819,348.76 


77,423.84 


59,475.38 


1952 


548,424.04 


77,799.12 


61,713.66 


1951 


481,302.08 


63,071.82 


52,816.34 



♦During the years 1951-1956, the company was operated as a partnership, 
fin 1954, the company suffered a loss of $6,921.26 on a contract having a 
value of $63,628. This was the largest loss incurred in recent years. 



128 



EXHIBIT 3 



Contracts Completed in 1957 



Contracts 

$ 9,061.10 

6,970.00 

82,493.66 

23,652.00 

6,114.00 

23,569.00 

147,164.00 
45,823.84 
58,011.66 

362,522.40 
33,600.00 
43,702.00 
27,731.08 
3,801,30 
90,199.76 
55,314.00 
14,070.00 
37,598.00 
30,206.06 
41,699.20 

$1,143,303.06 



Costs 



7 

6 
72 
24 

4 
22 
141 
41 
53 
320 
32 
37 
25 

3 
78 
47 
13 
29 
28 
35 



,390.38 
,566.60 
,055.38 
,136.52 
,838.70 
,141.30 
,677.58 
,250.24 
,530.28 
,875.78 
,705.52 
,265.74 
,872.30 
,110.62 
,103.42 
,195.98 
,556.50 
,630.64 
,995.40 
,213.22 



$1,026,112.10 



Profit 

$ 1,670.72 

403.40 

10,438.28 

(484.52) 

1,275.30 

1,427.70 

5,486.42 

4,573.60 

4,481.38 

41,646.62 

894.48 

6,436.26 

1,858.78 

690.68 

12,096.34 

8,118.02 

513.50 

7,967.36 

1,210.66 

6,485.98 

$117,190.96 



EXHIBIT 4 List of Subcontracts on Job #220 



1. Site work 

2. Concrete work 

3. Precast concrete panels 

4. Aluminum sash 

5. Sash erection 

6. Structural steel 

7. Glass & glazing 

8. Finish hardware 

9. Modern fold door 

10. Roofing & sheet metal 



11. Overhead doors 

12. Hollow metal work 

13. Resilient floor & base 

14. Hard tile 

15. Acoustical work 

16. Asphalt paving 

17. Plastering 

18. Painting 

19. Toilet partitions 

20. Curtain wall panels 



129 



EXHIBIT 5 



Balance Sheet as of December 31, 1957 



ASSETS 



Current Assets 

Cash in bank 

Cash on hand .... 
Accounts receivable 
Work in process . . 
Deposit accounts . . 
Notes receivable . . 



$ 74,317.34 

100.00 

61,715.04 

77,375.74 

2,341.86 

11,918.78 

$227,768.76 



Fixed Assets 



Trucks, tools, & equipment 

office furniture $12,922.98 

Less: Reserve for 

depreciation 2,090.66 



10,832.32 



TOTAL ASSETS . . 



$238,601.08 



LIABILITIES 



Current Liabilities 

Accounts payable— Trade 

Accounts payable— Misc 

Accrued taxes 

Accrued insurance 

Accrued management compensation 



$ 75,426.66 
3,503.24 

12,531.66 
2,079.00 

21,980.00 



Stockholders 



$115,520.56 



Stock $100,000.00 

Retained income 23,080.52 123,080.52 



TOTAL LIABILITIES AND CAPITAL 



$238,601.08 



130 



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131 



EXHIBIT 7 



APPLICATION 
FOR PAYMENT 



AIA 
FORM 

702 FIE «-D COPY 



ARCHITECT'S JOB No. 56133 



CONTRACTOR'S APPLICATION No. Four (4) 
PERIOD FROM Dec. 1 



to Dec. 31 



TO 



City of Burrlston 



PAYMENT, AS SHOWN BELOW, IN CONNECTION WITH THE 



OWNER. APPLICATION IS MADE FOR 

. Architectural WORK 



FOR YOUR 



Fire Station 



PROJECT 





DESCRIPTION 
OF WORK 


CONTRACT 
AMOUNT 


THIS APPLICATION 


C 


OMPLETED 
TO DATE 


BALANCE 
TO FINISH 




LABOR 


MATERIALS 




% 


* 


Performance Bond 


2,400 








2.400 


> 




Site Work 


3.500 








3.150 


350 


* 


Masonry 


51.200 


6.120 




90 


46 f 080 


4 r 120 




Concrete Work 


16.140 








8,910 


7 t 220 




Precast Concrete Panels 


25 f 520 


18,520 




72, 


5 18,520 


7,000 




Aluminum Sash 


8,030 










8,030 




Sash Erection 


1,700 










1,700 




Structural Steel 


24 f 580 








19,600 


4,980 




Glass & Glazing 


5,940 










5,940 


* 


Carpentry 


8,974 










8,974 




Finish Hardware 


3,080 










3,080 




Modern Fold Door 


740 










740 




Roofing & Sheet Metal 


6,600 










6 t 600 




Overhead Doors 


21,560 










21,560 




Hollow Metal Work 


6,640 








2,000 


4,640 




Resilient Floor & Base 


3,390 










3,390 




Hard Tile 


1,540 










1,540 




Acoustical Work 


3,300 










3,300 


* 


Chalkboard & Tackboards 


500 










\soo 


* 


Caulking & Weatherstrips 


1,020 










1,020 


* 


Aluminum Sign Allowance 


600 










600 


* 


Plaque Allowance 


400 










400 


* 


Exterior Louvers 


730 








7 30 




* 


Slide Poles 


0,020 




ft, 070 


89 


ft t 070 


i oon 




Asphalt Paving 


5,670 








?,«in 


^ftin 


* 


Fl«g Pole 


i t n?n 




7 SO 


73, 


; 7^n 


770 






4,710 










4 710 




P«int-fng 


3 190 










3 l Qn 




Toilet Partitions 


620 










620 


* 


General Conditions 


6,400 


1,000 




62. 


> 4,000 


2,400 




Curtain Wall Panels 


4.330 










4,330 




































TOTAL 


23 2,994 


25,640 


8,770 


50 


116,970 


116,024 



THIS IS TO CERTIFY THAT THE WORK AS LISTED ABOVE HAS BEEN COMFLETED IN ACCORDANCE WITH THE CONTRACT DOCUMENTS. THAT ALL LAWFUL 
CHARGES FOR LABOR. MATERIALS, ETC., COVERED BY PREVIOUS CERTIFICATES FOR PAYMENT HAVE BEEN PAID AND THAT A PAYMENT IS NOW DUE IN 
THE AMOUNT OF 



00 

Thirty Four Thousand. Four Hundred, and 10 100 



FROM WHICH RETAINAGE OF. 



10 



.% AS SET OUT If 



rHE CONTRACT DOCUMENTS SHALL BE DEDUCTED 

Net Billing 



DOLLARS (S 34,410.00 
S 3,441.00 



$ 30,969.00 
Charles Crowne Company CONTRACTOR 



Jj^_ 



19_58_ 



PER. 



■arry Shane 



132 



CASE 19 



Golden 
Stores, Inc. 



i 



n December 1960, Mr. James Voss, the treasurer of 
Golden Stores, Inc., was considering whether the 
company ought to extend to its 1960 published financial accounts a 
change in policy ( recently instituted for tax purposes ) , despite the strong 
opposition of Mr. William Robinson, the controller. The company had 
just completed arrangements for converting its tax accounting to the in- 
stallment basis for the bulk of its accounts receivable; the question be- 
fore Mr. Voss was whether the company should carry the change through 
to the Balance Sheet. The tax arrangement itself is described in more 
detail below; briefly, it involved the sale of all receivables to a banking 
syndicate for cash, and an immediate change in tax-accounting policy 
for all installment sales made after the conversion date. 



HISTORY 

Golden Stores, Inc., operated a chain of department and mail-order 
stores in the western United States. The chain had experienced a large 
expansion in recent years, through the opening of new stores and the 
continuing increase in the area's retail sales. Its financial condition was 
sound (see Exhibits 1 and 2 for Balance Sheet and comparative Income 

133 



134 Golden Stores, Inc. 

Statement data x ) . The past few years, however, had seen the growing 
entrenchment of liberal credit terms as a sales tool; 1959 had seen the 
company's credit sales reach 50 per cent of its total sales. This trend, 
although by no means new, had important implications from the point 
of view of the company's finances and accounting. 



CREDIT SALES 

Exhibit 2 indicates that credit sales increased from 41 per cent of $165 
million in 1955 to 50 per cent of $202 million in 1959, or from $67.65 mil- 
lion to $101 million. In other words, substantially all the sales increase 
in the past five years had been additional credit sales. Mr. Voss was 
perfectly aware of this trend. The company had, in fact, been stressing 
its credit facilities in order to win new sales, and would continue to do 
so in the future, bearing out the swing to consumer credit in the retail 
world. 

As treasurer, Mr. Voss was also very much aware of the effect that 
the company's expanding credit volume had on its financial needs. He 
pointed out that the company's receivables averaged eight months or 
more credit sales, and that the period was increasing annually. Obviously, 
this created a major need for financing to carry receivables. 

Two "long-term" credit plans were offered by Golden Stores to its 
customers. Almost all credit customers used one of these two plans; the 
volume of monthly-account sales was very small because customers 
usually preferred either to pay cash at the time of sale or to finance their 
purchases over a period of some months. 

The most popular plan was based on a regular installment agreement 
on some specific purchases. Customers would make a down payment on 
the articles they selected, and pay off the balance plus finance charges 
over an agreed period of time. 2 Most of the sales under this plan were 
so-called "big-ticket" items, such as household appliances and furniture, 
where single purchases would be made for large dollar amounts. 

In recent years, however, Golden Stores had also offered customers 
with proven credit worthiness the opportunity to finance their purchases 
of smaller items, particularly clothing, under a revolving credit plan. 
Under this plan, approved customers were permitted a monthly maximum 
purchase on credit. At the same time, they made a monthly payment in 
reduction of the unpaid balance on their account, the payment being 
calculated ( usually ) as one-twelfth of the total balance. In this way, one 



1 1959 was the last year for which complete financial information was available. 

2 The "add-on" for finance charges was 12% per cent on a year's contract, that is, 
8% per cent of the face value of the average account, on the basis of the eight- 
month average for accounts receivable. 



Colden Stores, Inc. 135 

year's credit was allowed, and customers could reutilize the credit granted 
to them as they paid off their account. A small finance charge was added 
to the monthly balance, usually 1 per cent. 



ACCOUNTING IMPLICATIONS 

The accounting policies applied to credit sales had been determined 
when these sales were only a small proportion of Golden Stores' total 
volume. Normal accrual accounting was used: the sale was entered in 
the books when made, and accounted for as a complete transaction at 
that time. In other words, the profit on the sale was recognized when 
the sale was made. Finance charges, representing a charge by Golden 
Stores for the capital tied up in a customer's account and for the expenses 
that it would incur in servicing the account, were taken into income on 
a time basis, according to the monthly balances on accounts receivable. 
Only the installment plan purchases carried a "pre-paid" finance charge, 
and this charge was deferred for balance sheet purposes as a valuation 
reserve deducted from accounts receivable. Revolving credit charges 
were assessed monthly, and there was accordingly no need for any de- 
ferral of these charges. 

During 1960, as a continuing rise in credit volume was sustained, it 
had become apparent to the company's management that their present 
policies, in effect, produced two possibly unfortunate results. First, im- 
mediate recognition of the profit on credit sales meant that income taxes 
had also to be provided for, and therefore, paid out, often before a major 
part of the sales price was received in cash. Second, immediate recogni- 
tion of profit on credit sales meant that the company's financial state- 
ments indicated a source of funds from profits that was, in a considerable 
amount, counterbalanced by an application to increased investment in 
working capital. Both of these results tended to make management's 
task more difficult: the first, because of the cash drain, and the second, 
because of the misleading source of funds that was being indicated. 

CHANGE FOR TAX PURPOSES 

During 1959, Golden Stores' tax consultants pointed out to the com- 
pany's management that it would be possible for the company to defer 
paying income taxes on the profit from its installment sales until the 
actual cash was received. The Internal Revenue Service permitted com- 
panies such as Golden Stores to prorate the gross profit on such sales over 
the period in which payment was received (Regulation #1.453-1), by 
application of the gross profit percentage only to those payments actually 
received (in effect, by deferring the gross profit on receivables still out- 



136 Golden Stores, Inc. 

standing). This was known as the "installment method" of accounting. 
However, the tax authorities required a complete switch-over to this 
basis if a taxpayer proposed to adopt it. Furthermore, in order to avoid 
double taxation in the year following the change-over, it was necessary 
for the company to realize all its receivables fully at the end of the year 
before the change-over. When the new system took effect, the gross profit 
percentage would be applied to all receipts in years following the change- 
over, even though tax had already been paid on the profits "included" in 
receivables from past sales and recognized when the respective sales were 
made. (The provisions for tax relief were not regarded as sufficient to 
avoid some element of double taxation, so that the complete-sale concept 
was the only sure way of avoiding any possibility of this penalty. ) 

This scheme appeared to be most attractive to Golden Stores' manage- 
ment, as it would certainly permit deferral of income taxes on installment 
sales income not yet realized in cash. Some confusion existed as to the 
inclusion of revolving-credit plans under this regulation; the IRS refused 
to agree that a similar treatment was permissible until the matter had 
been adjudged by the Superior courts. However, it was expected that 
revolving-credit plans would, in time, be included under this regulation, 
so that all income on long-term credit sales could be deferred for tax 
purposes. 

In the meantime, the prospect of deferring at least some income taxes 
was attractive enough to the company. Arrangements were made for a 
group of commercial banks to purchase all Golden Stores' receivables as 
of the end of the latter's 1960 financial year. In this way, the company 
realized, in cash, all the sales it had made up to December 31, 1960, paid 
income taxes on these sales in 1960, and was free to elect the installment 
basis of accounting for tax purposes beginning January 1, 1961— which it 
did. 



CONTROLLERS VIEWPOINT 

There was, of course, no obligation on the company to use the install- 
ment basis of accounting in its regular financial accounts. As a matter of 
fact, Mr. William Robinson, the company's controller, had expressed him- 
self as being strongly opposed to any change in the regular accounting 
basis, previously described. Mr. Robinson stated as his opinion that 
changes made for tax accounting had no relevance as far as the company's 
reported profits were concerned, other than the necessary recognition 
of tax deferrals. He felt that any change would undermine the basis of 
accrual accounting that had always been used, and would distort the 
meaning of the "gross profit from sales" concept. Mr. Voss was not at all 
confident that he could summon up sufficient argument in favor of a 






Golden Stores, Inc. 137 

change; after hearing Mr. Robinson's point of view, he began to have 
serious doubts as to the propriety of a change along the lines that he 
had been considering. 



Required 

1. Recalculate Golden's net income before taxes for the years 1955-1959, fol- 
lowing the policy of deferring recognition of the gross profit on all install- 
ment sales made from January 1, 1955. Assuming a 50 per cent income tax 
rate, how valuable would this change in policy have been to Golden if it 
had been adopted on January 1, 1955? 

2. What factors should Mr. Voss consider in his decision regarding deferred 
income for regular corporate reporting? Should he differentiate between 
income presently deferrable for tax purposes (installment sales) and that 
not deferrable (revolving-credit plan)? Do you think that all retail busi- 
nesses should use the installment method of recognizing gross profit? Why? 
Do you think Golden should adopt this method for reporting to its stock- 
holders? 



EXHIBIT 1 



Consolidated Balance Sheet at December 31, 1959 
(All Amounts in Thousands) 



Current Assets 



Cash and U.S. treasury bills 

Accounts receivable (less $5,900 reserve*) 
Inventories, at lower of cost and market . . 
Prepayments 



Total Current Assets 
Investments, at or below cost 



Property, plant and equipment: cost $28,278 

less: depreciation 

Net 

Debenture discount 

Total Assets 





$ 10,755 

68,540 

35,278 

1,434 




$116,007 




10,671 


$28,278 
12,474 


15,804 
169 




$142,651 



Current Liabilities 

Accounts payable $ 5,118 

Accrued expenses 4,638 

Federal income taxes 7,355 

Other taxes payable 3,694 

Short term notes payable 30,217 

Total Current Liabilities .... $ 51,022 

5% debentures, 1996 17,500 

Stockholders' Equity 

Capital stock-$1.00 par value $11,250 

Paid-in surplus 3,420 

Retained earnings 59,459 

Total Stockholders' Equity ... 74,129 



$142,651 



♦Comprising deferred finance charges on installment accounts and a 
provision for bad and doubtful debts. 



138 



EXHIBIT 2 


Comparat 


ive Income Statement Data, 1955 t 
1959 1958 1957 1956 


o 1959 






1955 


($'000,000) 












Net sales 


$202 


$186 


$180 


$178 


$165 


Net income before taxes 


20.2 


16.9 


16.7 


17.2 


16.7 


Year -end receivables (net) 


68.5 


58.7 


54.0 


50.4 


44.4 


(see Exhibit 3) 












(Percentages) 












Realized gross margin* 


36.0% 


35.3% 


35.4% 


35.8% 


36.0% 


Credit sales/ total sales 


50 


47 


46 


44 


41 


Installment plan 


37 


38 


39 


38 


37 


Revolving credit 


13 


9 


7 


6 


4 



*Gross margin (sales, less cost of goods sold), expressed as a percentage of 
net sales. 



EXHIBIT 3 



Accounts Receivable Data, 1955 to 1959 
(December 31) 



1959 1958 1957 1956 1955 



($'000,000) 
Installment accounts 
Revolving charge accounts 
Miscellaneous accounts 

Less: Reserve* 
Net Total 
*See note to Balance Sheet. 



$59.2 


$54.7 


$51.2 


$48.0 


$42.6 


12.8 


6.6 


4.8 


4.0 


2.5 


2.4 


2.9 


3.0 


3.1 


3.6 


$74.4 


$64.2 


$59.0 


$55.1 


$48.7 


5.9 


5.5 


5.0 


4.7 


4.3 


$68.5 


$58.7 


$54.0 


$50.4 


$44.4 



139 



INVENTORY VALUATION-DETERMINATION 
OF COST OF GOODS SOLD 



CASE 20 



R. H. Shay 

Motor Company, Inc. 



i 



n mid-February 1961, Mr. David Whittlesey, a 
student attending a business school, contacted the 
Shay Motor Company in his search for a used automobile. He had re- 
ceived a check for $600 from his parents for Christmas, but did not have 
the time to search for a suitable car until the first semester had ended. 
He found a 1956 Ford Fairlane sports sedan at Shay's, but did not feel 
it was worth the asking price of $750. When he offered Mr. Shay $600 
for the car, he was very much surprised at his reply that, "The auto- 
mobile business is terrible! IVe only been in business one month, and I'll 
be very lucky if I'm here next month. Do you know that I lost nearly 
$25,000 last month? I should have kept my job as manager of the auto- 
motive department at Starr Burnham and Company and never put my 
life savings into this darn automobile business. I can't sell you that car for 
$600 and make any money; in fact, I'd lose money on a deal like that." 
That evening, after discussing Mr. Shay's comments with several of his 
friends, Mr. Whittlesey decided that Mr. Shay's situation might serve as 
the subject material for a required report in one of his courses. Subse- 
quently, he contacted Mr. Shay who agreed to give Mr. Whittlesey the 
required information in return for his advice based on his report findings. 

140 



R. H. Shay Motor Company, Inc. 141 

COMPANY HISTORY 

Mr. Shay had been manager of the automotive department at a near-by 
retail store of Starr Burnham and Company since 1945 but was not satis- 
fied with this position because he had always wanted to own and manage 
his own business. He had kept his eyes open for a potential investment 
opportunity and when he found that Bert Motor Company was for sale, 
he decided to purchase the business. In late December 1960, a purchase 
price of $125,000 was agreed upon, of which $85,000 was to be paid to 
Bert's as of the date of sale. The balance was to be paid annually at the 
rate of 10 per cent of reported annual profits. This balance ($40,000) 
carried a 4 per cent interest rate, payable semiannually. Mr. Shay was 
able to assemble the required $85,000 by drawing on three sources. First, 
he invested $40,000 of his own personal savings; second, he obtained 
$25,000 from his father on a 3 per cent note; and finally, he borrowed the 
remaining $20,000 from the Community National Bank under a 5 per cent 
loan which was secured by the new car inventory. Mr. Shay listed the 
assets he had purchased from Bert Motor Company as of January 1, 
1960, as follows: 

Accounts Receivable 

From sale of repair parts and mechanical servicing to customer's cars . . $ 15,400 
Advertising Brochures and Literature 

Relative to 1961 model cars 1,700 

Ford Dealer Franchise 25,000 

Leasehold Improvements to Showroom and Service Building 

Mr. Shay obtained a lease agreement on the building for a fifteen-year 
period. He paid Bert Motor Company for certain improvements which Bert 
had made to the building, such as restrooms, decoration of the showroom, 
and installation of certain lighting and advertising signs. Mr. Shay esti- 
mated these improvements would last as long as the building or approxi- 
mately fifty years 12,860 

Mechanical and Office Equipment 

Tools, lifts, air compressors, and other miscellaneous shop and office 
equipment. It was estimated that the useful life of the equipment was 

approximately ten years 14,320 

New Cars in Stock 

Mr. Shay purchased a stock of thirteen new cars from Bert Motor Com- 
pany. These cars had an invoice cost ( cost to the dealer, including freight 
from the nearest port of entry) of $29,826, but were expected to sell at 
retail (retail list price as suggested by the manufacturer) for $36,126. . . 36,126 

Office Supplies Inventory 1,196 

Repair Parts, Supplies, and Accessories Inventory 16,813 

Used Cars in Stock 

Bert Motor Company had two used cars on hand as of January 1, 1961. 
The expected retail value of these cars was $2,490, the Blue Book Whole- 
sale Value was $1,585, the loan value was $1,375, and $2,945 had been 

allowed on those cars when they were traded in on new cars 1,585 

Total Assets, Purchased from Bert Motor Company $125,000 



142 R. H. Shay Motor Company, Inc. 

In addition to these assets, Mr. Shay was able to obtain an additional 
$25,000 from the Community National Bank under a 5 per cent working 
capital loan secured by the new car inventory and the accounts receivable. 
The bank stipulated that the total loan of $45,000 was to be reduced at 
the rate of $500 per month, whereas interest was payable annually. With 
these assets, Mr. Shay formally announced he was open for business on 
January 1, 1961. 

Bert's was a relatively small, new-car Ford agency located in one of 
the suburbs of Boston, Massachusetts. The original company had been 
established in 1920 and had grown rapidly until 1940. However, the 
agency had never regained much headway subsequent to World War II 
and after Mr. Bert's death in early 1960, the decision was made to sell 
the dealership. Bert's had no used-car sales department because all 
trade-ins had been wholesaled at the auction block for whatever they 
would bring. 

Mr. Shay thought he could run the agency as a profitable venture by 
selling the trade-ins at retail, rather than wholesaling them, by stressing 
the quality and dependability of his "selected" used cars, and by stressing 
the importance of the quality servicing he would provide on any new 
or used car which he sold. In addition to increasing sales, Mr. Shay felt 
he could cut down on overhead expenses because he intended not only 
to act as manager of the agency, but also to serve as new car sales 
manager; his wife, Sally, would act as office manager and bookkeeper 
for the agency. She had previous experience as a clerk-typist in the 
business office of a large manufacturing firm, but she had no accounting 
experience or training. 



OPERATING RESULTS FOR JANUARY 

On January 31, 1961, after one month of operation, Mr. Shay and his 
wife were very anxious to learn if they had operated the business success- 
fully during the month of January. They both felt that business had 
progressed smoothly in that month, and during a discussion with Mr. 
Jacobs ( former manager of Bert Motor Company ) they learned that they 
had sold more cars this January than Mr. Jacobs had sold in the same 
month of the preceding year. 

They had sold fifteen new cars priced at the manufacturer's suggested 
retail price of $42,365 and had received $4,305 cash, installment notes re- 
ceivable of $26,340 (which were immediately sold to Community Na- 
tional Bank for $24,495 cash); twelve used cars on which trade-in al- 
lowances of $10,620 had been made, and had given cash discounts of 
$1,100 on three of the new cars, in exchange for the $42,365 of new cars. 
The factory invoice cost of the fifteen new cars was $31,145. Mr. Shay's 



R. H. Shay Motor Company, Inc. 143 

used-car sales manager estimated that the twelve used cars traded in 
would bring about $8,620 on the retail market but would only bring 
$6,490 at the wholesale auction block (often referred to as "Blue Book" 
value) and had a loan value of only $5,300. In addition to the new car 
sales, six used cars had been sold in January for a cash price of only 
$5,213 although $6,486 had originally been allowed on the cars at the time 
they were traded in on new cars. 

During the first few days of February, Mrs. Shay worked feverishly 
preparing a profit and loss statement for the month ending January 31, 
1961, but was horrified when she determined that a net loss of $24,467 
had been incurred for the month of January ( see Exhibit 1 ) . When Mr. 
Shay saw the statement, he too was shocked and disillusioned for he felt 
that he and his wife had worked exceptionally hard during the month and 
should have made money on the sales that had been made. 

When Mr. Shay had shown the statement to his used-car sales manager 
( who was paid a salary of $300 per month plus 10 per cent of the profits 
on used-car sales), he had been told that this statement, showing a loss 
of $1,273 on used cars, did not reflect the profit made on used-car sales 
and that the statement was a very unfair presentation of the profitability 
of the used-car operation. 

The used-car sales manager's final comment had been, "You're going 
to lose yourself a good employee if you try to pull a fast one like that on 
me. You and I both know that the six used cars I sold could have been 
purchased wholesale at the block for $2,800 or $2,900, and thus the used- 
car operation would have shown a $2,400 profit for the month. Not only 
that, but I've heard you comment several times that you'd give a 15 per 
cent discount on a new-car sale if no trade-in was involved, and that 
means that the cost of every used car you expect me to sell is inflated by 
at least 15 per cent. I think you'd better take a good look at the used-car 
profit calculation!" 

At this point, Mr. Shay began to wonder if his decision to purchase the 
automobile agency had been completely in error and if he might not 
have been better off by keeping his steady job at Starr Burnham. 

Required 

1. Prepare a balance sheet as of January 1, 1961, and as of January 31, 1961, 
for Mr. Shay. 

2. Do you think that Mrs. Shay's operating statement correctly presents the 
profitability of the Shay Motor Company, Inc., for the month of January 
and if not, how would you change her statement? 

3. As Mr. Whittlesey, what comments or suggestions would you make to Mr. 
Shay about the progress of his business to date? 

4. What problem or problems will Mr. Shay face in trying to assess the prof- 
itability of the new-car versus the used-car operation? 



EXHIBIT 1 



Statement of Profit and Loss for the Month Ending 
January 31, 1961 



Income from Sales 

Collections on accounts receivable $ 4,800 

Cash sale of repair parts, accessories, and customer servicing. 

(This did not include sales of $24,670 made in January but which 

had not been collected prior to January 31, 1961) 18,080 

Cash collected on new cars sold in January 4,305 

Cash collected on sale of installment notes to Community National Bank 24,495 

Used-car sales $5,213 

Less trade-in value allowed on cars 

when originally traded in 6,486 (1,273 ) 

Net income for January $50,407 



Operating Expenses 

Salaries and wages 

Salaries and wages were paid weekly. This amount represented 
net salaries paid by check through the week ending Friday, 
January 27, 1961. The number of people on the payroll was con- 
stant during the month of January. The normal work- week was 
five and a half days $23,315 

Insurance, liability, uninsured motorist, fire and theft 

This premium paid for coverage under a three-year policy 

contract 4,850 

Advertising supplies, brochures, and pamphlets purchased in January . 685 

Hot-topping and construction of used-car sales shack. 

This was the cost of preparing a vacant lot for use as used-car 

sales space. The lot had been secured under a five-year lease 

agreement but the improvements to the lot were estimated to 

have a twelve-year life 7,400 

Heat, light, and power 

Was paid on a bimonthly basis. The first billing would not be 

made until March. The charge for the equivalent two-month 

period last year was $2,384 



Real estate and property taxes had been assessed in the amount of 

$8,232 and were to be paid in equal semiannual installments on 

June 30 and December 31. 

Sub- Total (Forward) $36,250 

(cont'd) 



144 



EXHIBIT 1, cont'd 



Forward $36,250 

Repair parts, supplies, and accessories purchased during the month 

$10,000 of this amount had not been paid by 1/31/61 14,589 

Federal and State taxes withheld from employees' salaries and wages 
paid in January. These taxes were remitted to the proper agen- 
cies quarterly. 2,800 

Purchase of office supplies during January 435 

Mr. Shay's drawings for January 2,000 

New cars purchased from Ford Motor Company (12 cars total invoice 
cost $28,380, one-half down before delivery, balance due at time 
of final sale. The suggested retail price on these cars was 
$36,880.) 14,190 

Miscellaneous operating expenses paid in January including loan re- 
payment of $500 to Community National Bank and a home 
mortgage payment of $210 on Mr. Shay's private residence. . . . 4,610 



Total Operating Expenses $74,874 

Net operating loss for January ($24,467) 

Supplemental Month End Account Balances 

Inventory Accounts 

A physical count (valuation at cost) of the various inventory accounts 
revealed the following balances as of January 31, 1961. 

Office supplies $ 1,332 

Repair parts, supplies, and accessories . 20,880 
Advertising brochures and literature .. 1,902 

Cash Balance as of January 31, 1961 

Shown on the bank statement received from Community National Bank, $23,540. 
However, checks amounting to $3,721 had not been presented to the bank 
for payment as of the date of this statement. 



145 



CASE 21 



Showdown 
at Sunset Pass 



i 



n June 1960, the newly formed business enterprise 
Cine-Mesa, Inc., went "on location" near Laramie, 
Wyoming, to produce a film entitled Showdown at Sunset Pass. The script 
for the film had been adapted by the author from It's Dark at the Top of 
the Pass, a recent novel about life in the Old West. The book had main- 
tained a high place on the "best seller" list since its publication early in 
1959. 

Cine-Mesa, Inc., had been organized as a corporation for the express 
purpose of producing this "adult western" movie. Sixty per cent of the 
authorized 100,000 shares of no-par common stock was held by the co- 
stars of the production, Mr. John Bain and Miss Shirley Gibson. Mr. Bain 
held 35 per cent, and Miss Gibson 25 per cent. Mr. Ian Kalif, the 
producer-director, held 10 per cent, and the remaining 30,000 shares had 
been sold at $15 per share to a fairly large number of individual investors 
who frequently participated in such film enterprises. The $450,000 pro- 
ceeds from the "publicly held" stock represented the only cash paid into 
Cine-Mesa by its shareholders. Mr. Bain had agreed to accept responsi- 
bility for the additional financial backing and had found no difficulty in 
securing the funds as needed under loan arrangements. 

Although neither John Bain nor Shirley Gibson was known primarily 
for Western-type films, Mr. Bain was generally regarded as among the ten 
top current box-office attractions in the United States. Miss Gibson's 

146 



Showdown at Sunset Pass 147 

ranking was not as high, but she was a successful actress whose services 
were widely sought. In addition to a share of the Corporation's profits 
from the Showdown at Sunset Pass production, each of the co-stars was 
to draw a salary during the first year. Mr. Bains salary was to be $100,000, 
Miss Gibson's $60,000. No additional salaries would be paid to either 
of them. 

The film rights to It's Dark at the Top of the Pass and the author's 
script adaptation had been purchased under an arrangement whereby 
the author and his publisher would receive either an outright payment 
of $60,000 plus a 5 per cent of the after-tax profits from the film, or 
$200,000, whichever was larger. The remaining profits were to be dis- 
tributed to the Corporation's stockholders according to their share 
holdings. 

In addition to the amounts to be paid the co-stars, there were salaries 
for the supporting cast, the producer-director, musicians, and the pro- 
duction crew, expected to total about $600,000. It was estimated that 
travel and other expenses while "on location" would amount to $150,000. 
There would also be the cost of negative and positive films, wardrobes, 
props, and accessories totaling $100,000. General administrative and other 
miscellaneous items of expense were expected to amount to $80,000. 

Some of the materials for sets to be used in the film production had 
been obtained under a rental arrangement from Mr. Kalif, who had 
previously produced a less elaborate Western at a location about a hun- 
dred miles from Laramie. The total cost of $75,000 for renting and moving 
these sets had already been agreed upon by Mr. Bain and Mr. Kalif. In 
addition to these costs, Cine-Mesa would probably spend $200,000 for 
sets. This expenditure might be partially offset by the later sale or rental 
of the sets in somewhat the same manner that Cine-Mesa had rented 
old sets from Mr. Kalif. 

Cine-Mesa had been approached by Mr. Ted Flannigan, the producer 
of a Sunday evening variety show which had long attracted wide audi- 
ences on one of the major television networks, with a request that he 
show on his program sometime in December 1960 some of the more grip- 
ping excerpts from Showdown at Sunset Pass. Mr. Flannigan would visit 
the set at his own expense and film an interview between him and some 
of the cast. This interview would be shown on the program just preced- 
ing the showing of the excerpts. The expenses incurred by Cine-Mesa 
in this connection would be hard to isolate and measure, but Mr. Kalif 
thought they would probably not exceed $5,000 and might be as low as 
$2,000. Mr. Kalif considered in his estimate the fact that there would be 
some minor interruptions of the filming and that Cine-Mesa would supply 
the film excerpts. Mr. Bain had stated that this arrangement together with 
his and Miss Gibson's planned personal appearances could be worth 
$100,000 or more to Cine-Mesa. 



148 Showdown at Sunset Pass 

Most of the costs to be incurred during the life of the Corporation 
would be the production costs described above and would be incurred 
during the first year. However, there would be an annual cost of perhaps 
$50,000 to take care of administrative matters that would arise throughout 
the life of the Corporation. The Corporation could be dissolved at any 
time by a vote of two-thirds of the stock. As a practical matter, such dis- 
solution would take place when the expected future revenues, less operat- 
ing costs, were not sufficient to warrant the continued investment of the 
funds that could be realized by the sale of the remaining film rights to 
another party. 

Although Cine-Mesa had no full-time financial and accounting officer, 
the Corporation did have at its disposal the advice and part-time services 
of Mr. Stanley Corder, a Certified Public Accountant practicing in the Los 
Angeles area. Mr. Kalif, who had officially accepted responsibility for 
financial and accounting affairs, had little interest and almost no training 
or experience in such matters. He made it clear in their first conference 
that he would depend heavily upon Mr. Corder for advice. He com- 
mented, however, that the one man in the Corporation who would take 
a strong personal interest in Cine-Mesa's financial and accounting prob- 
lems was the star, Mr. Bain. 

After Mr. Corder's first talk with Mr. Kalif, he realized that there were 
several factors which complicated the accounting problems at Cine- 
Mesa. He knew that he would have to recommend a schedule for amortiz- 
ing the costs associated with producing Showdown at Sunset Pass. Mr. 
Kalif had said that he would have supposed that the thing to do would 
be to estimate the number of years the picture would run and use that 
period as a guide. He stated that there had been other "major Western" 
films which might provide some statistical basis for estimating the life of 
Showdown. Mr. Kalif had also mentioned later that, since there was some 
chance that the Corporation would realize substantial revenues from tele- 
vision showings of the picture after it had completed its run in movie 
houses, perhaps some of the costs should be associated with that source 
of revenue. The television proceeds might result from royalty arrange- 
ments or from an outright sale of the film for television showings. In ad- 
dition, there was the possibility of a re-release of the film for movie 
houses at some date well in the future. 

Mr. Corder suggested that it might be desirable to try to estimate the 
revenues by years and use those estimates as a basis for amortizing the 
costs. He said that he would guess that the first year of showing would 
be the period of greatest revenue. Mr. Kalif was not at all sure that the 
first year would be the largest revenue-producing period. He pointed 
out that Showdown at Sunset Pass would have several attributes which 
made it suitable for a first run on an advanced-price, reserved-seat basis. 
The picture had been adapted from a widely read book; it had big-name 



Showdown at Sunset Pass 149 

stars; and it would be filmed in a new color process called Western-Glow. 
All of these would make the film somewhat unique insofar as sales pro- 
motion was concerned. 

If Showdown were shown on a reserved-seat basis on its first run, the 
impact on the revenue pattern, according to Mr. Kalif, would be hard 
to estimate. He thought that reserved-seat runs sometimes drew people 
who would not have seen the film on a regular popular-price first run. 
It would, of course, also mean that many people who would have seen it 
on a popular-price first run would not see it until later; and in fact, some 
would never see it because they would not feel they could afford the 
advanced prices on the first run and would lose interest by the time the 
film appeared at popular prices. And, as Mr. Kalif pointed out, advanced- 
price, reserved-seat showings covered a relatively small proportion of 
the movie theaters in the country. The total effect, therefore, might be 
that the major flow of revenues from the film would be pushed into the 
second year, with the result that receipts would be greater in total if 
the film were run first on a reserved-seat basis but spread out over a 
longer period of time. 

Mr. Bain and Mr. Kalif expected that by December 31, 1960, the date 
selected as the end of the business year for Cine-Mesa, no revenues would 
have been realized from Showdown at Sunset Pass. The first showings 
would probably take place in January or February of 1961. Mr. Bain 
thought it would be desirable, however, to issue some kind of financial 
statement to the stockholders at that time. He was most anxious to 
establish good relationships with these investors to whom he might go 
from time to time for financial backing. He wondered what the December 
31, 1960 statement should include in the way of information about 
revenues. Although no cash would have been received, there would un- 
doubtedly be a large number of firm bookings by that time. Mr. Kalif 
had asked Mr. Corder whether these bookings could be shown as revenue 
in a profit and loss statement. All that remained for Cine-Mesa was the 
actual physical delivery of the film copies, and this Mr. Kalif considered 
a minor matter that was almost automatic once the film editing had been 
completed. 

Mr. Bain had raised one other question that had occurred to him. He 
was sure that at some point the Showdown film would be adapted for 
showing in several European countries. Mr. Bain thought it very likely 
that any proceeds from European showings would not be brought to the 
United States but left on deposit in European banks for use in late 
1961 when he planned to produce a picture in Southern Europe. He 
wondered how he could show these facts in the reports to stockholders. 
He was certain that there would be no problems in working out an ar- 
rangement between him and Cine-Mesa, Inc. 



150 Showdown at Sunset Pass 



Required 

As Mr. Corder, what accounting problems do you see and what accounting 
policies would you prescribe for Cine-Mesa, Inc., in the preparation of 
financial statements for December 31, 1960, and for future years? Mr. 
Corder was especially puzzled at just what constituted inventories in such 
an enterprise as Cine-Mesa, Inc. You need not be concerned about income 
taxes. 



CASE 22 



Jordan Marsh 
Company (A) 



i 



n July 1960, Mr. Donald F. Lynch, staff assistant 
to Mr. William E. Tilburg, controller and assistant 
treasurer of the Jordan Marsh Company of Boston, Massachusetts, was 
explaining the operation of some of the company's accounting systems 
to John D. Cook, a newly appointed assistant buyer. 

"As you know," he said, "Jordan Marsh has three stores in Boston ( the 
main store, the annex, and the basement), but we also have branches at 
Framingham, Maiden, and Peabody. However, we treat the whole com- 
plex as a unit, for administrative purposes. Here at my office we collect, 
record, and analyze financial data pertaining to all the stores. Similarly, 
a buyer's function is related to his department, which may operate in 
the Boston store and all the branches. To give you an idea of our size, 
our annual volume is in excess of $100 million; we have nearly 7,000 em- 
ployees, and something like 300 different selling departments. 

"Each six months we prepare our Operating Statement for each de- 
partment. This is one of the things that top management looks at in 
evaluating the performance of each buyer. In order for you to under- 
stand how we prepare this statement, let me explain how our record- 
keeping system operates. I want you to understand this system thoroughly 
because it is so important in measuring your department's profit. 

"Our whole system is geared to inventory control. You're going to be 

151 



152 Jordan Marsh Company (A) 

in Mens Suits. You know how many different styles, sizes, and fabrics 
there are there. Try to visualize the same complexity in 300 other de- 
partments, and multiply that by four, for our four locations. My office 
has to keep track of all that inventory. In total, inventory amounts to one 
of our major assets. We just have to have a workable control system. This 
holds good on a store-wide basis, and right on down to each department, 
like Men's Suits, which is where you come into the picture. 

"If we were selling automobiles, it would be relatively simple for us 
to keep unit records for each car. That would give us easy, positive iden- 
tification and control. But we don't have unit records in a department 
store. Physically, that would be almost impossible, and we don't need 
that kind of control. We're satisfied if we can prove, periodically, that our 
physical inventory adds up to what the books say it is. To get this proof, 
we have to count it all up, and we do that twice a year, at the end of 
January and the end of July, when our inventory is at its seasonal low." 

"But Mr. Lynch, that means you have to list it all, work out somehow 
what it cost (I suppose by price-ticket coding or by checking records 
made when things were purchased ) , and add it all up. That must be some 
job!" 

"It would be, John, but we don't do it that way. You see, as I said 
to you before, we build our inventory control system into our other record- 
keeping. When a buyer orders goods, he records, at that time, the retail 
prices to be marked on each item. This is how the marking department 
gets its instructions. Our statistical office also gets this information, and 
they can compute the retail value of each order. Add all orders together, 
at retail, deduct sales (by definition, at retail!), and the difference is the 
ending inventory, at retail, if you started with no inventory. Next period, 
you know the starting value of inventory at retail, you go through the 
whole process again, and get your new inventory figure. It's as simple as 
that. Then you come along, you tell me that you added up the retail, 
marked prices on the merchandise in your department, and I compare 
your figure with what the books show it should be." 

"Very neat! But that figure is the retail value. Do you put that in the 
balance sheet? Isn't it a bit risky?" 

"No, we put cost in the balance sheet and the income statement. Our 
statistical office keeps a running record of not only the retail values but 
also the cost price of purchases. Then they can tell us what the average 
markup is on all goods handled. Let's say it's 35 per cent ( and we always 
reckon it on selling price ) . That means that the cost of goods handled is 
65 per cent of the total retail value. We call this the cost complement. 
We simply multiply the retail value of inventory by the cumulative cost 
complement, and we have the cost, in dollars." 

"Can we go back a moment, Mr. Lynch? I know Jordan's has special 
sales sometimes, when prices are reduced. Now this would mean that a 



Jordan Marsh Company (A) 153 

sale at a special price would not absorb all the cost and markup at- 
tributable to the item concerned. I mean that if a suit cost Jordan's $35, 
and was marked up $14 to $49, but sold in a clearance for $45, there 
would be $4 left in the inventory account— and no suit! Then our actual 
inventory count would show up a 'shortage' of $4 when we compared 
it with your figures." 

"That's all taken care of, John. Goods can't be marked down, without 
special authority. When that authority is given, it has to be in writing, 
to the marking department, over the buyer's signature. The statistical 
office picks it up in the same way as they tabulate markups, and we allow 
for it in computing the book value of inventory. Here, why don't we take 
a look at your department's figures, and actually see how it all works out. 
We'll take the last complete season, the one ending January 31, 1960. 

"Here's the schedule of what we call 'retail reductions' for your de- 
partment, Men's Suits, for that season [Exhibit 1]. This is a summary, 
built up monthly, of all transactions that will reduce the retail value of 
opening inventory plus purchases. As I said, the markdowns authorized 
by each buyer ( we call them 'regular markdowns' ) are tabulated by the 
statistical office. The office also tabulates special price reductions ( mainly 
to employees) which we call 'discount markdowns.' Add these two cate- 
gories of markdowns to sales, and we have total retail reductions. 

"Now look at this one— the inventory account [Exhibit 2]. We start 
with the retail value of the opening inventory, and the cumulative cost 
complement of 63.65 per cent gives us its cost equivalent. Each month 
we add the cost and retail values of purchases to the relevant columns. 
As by-products, we determine the monthly markup percentage and the 
cumulative cost complement. Then each month we deduct the cumulative 
retail reductions from the cumulative retail value of opening inventory 
plus purchases, to determine the book value of inventory, at retail. We 
multiply this by the cost complement, and we have the assumed cost value 
of inventory. 

"You'll note that the records showed that the Men's Suits department 
should have had an inventory of $88,410, at retail, at January 31, 1960. 
However, the physical stock count revealed an inventory of only $85,860, 
or a shortage of $2,550 at retail. We made allowance for this by using 
the figure from the actual count as the January closing figure. This loss 
is about 0.5 per cent of sales for the period, and is, in fact, slightly less 
than we expected. 

"Now take a look at this sheet— the departmental gross margin statement 
[Exhibit 3]. We prepare these monthly for each department, for your 
division manager. You won't get to see these monthly, but let's go over 
it anyway. Gross margin is simply sales less cost of sales (including 
alteration expense). We don't have a separate column for cost of sales- 
just subtract its elements from cumulative sales to get cumulative gross 



154 Jordan Marsh Company (A) 

margin. Now, what you're going to get (at least, your boss is), is the 
six-monthly seasonal departmental operating statement. Here's a copy 
[Exhibit 4]. 

"This statement is the formal record of departmental performance. 
All the buyers' decisions are reflected in there in one way or another. A 
lot of the calculations are made on these three other statements, but 
everything finally ends up on the departmental operating statement. 
You must have some questions!" 

"Yes, I do. I hardly know where to start! Let's see, now. From what 
you've shown me, I presume that you have a separate calculation for each 
department's cost complement. By inference, you must be assuming that 
the composition of the final inventory is proportionately the same as that 
of opening inventory plus purchases. I mean, I assume that there's not 
an exact markup of 36.5 per cent on each and every item purchased ( in 
fact, I know there's not, because each month's average markup varies 
slightly). This 36.5 per cent is just an average— the average of all goods 
handled. You apply its complement to the closing retail inventory. But 
the resulting 'cost' figure can only be accurate if the closing inventory 
is a miniature version of what went into the calculation of that average 
of 36.5 per cent. 

"I should think that some lines must move faster than others. They're 
probably marked up slightly less than a 'typical' line. This would tend 
to pull the average markup down, or increase the cost complement. This 
in turn would result in overvaluation of all items with a lower cost com- 
plement. Get me?" 

"I know what you mean, John. In a way, I mean theoretically, you're 
right. If we wanted to be really accurate, we would have separate cate- 
gories and calculations for each markup percentage group. So why do 
we make our groups up at the department level? Convenience, perhaps? 
Not really. The fact is that we are satisfied, on the basis of long experi- 
ence, that the cumulative cost complement is a good, true, and accurate 
measure to use. There just isn't any violent disparity, within a department, 
between markups on slow and fast lines. If there ever is, at any one time, 
it's a purely temporary phenomenon, and quite likely to be counter- 
balanced by an opposite effect at a later time. It's conceivable that there's 
not one article in your department with an exact markup of 36.5 per cent. 
That's not the issue. That figure, we feel, is an accurate, weighted measure 
of the markup averaged on your turnover." 

"Hmm. But there's another point where I really think the system could 
be improved, because as it stands, it's mighty unfair to the buyers. Look, 
each department's gross margin performance is a reflection of its buyer's 
ability. Right? Now, when I learned about accounting, I found out that 
it only reflects realized profits. It seems to me that the way you're handling 
markdowns contradicts that rule. 



Jordan Marsh Company (A) 155 

"You're treating regular markdowns as retail reductions as of the time 
at which they are effected. I think there might be some merit in this if all 
the marked-down goods were sold, or when they're sold. But if any 
remain in inventory, and you use the cost complement on their new 
lower retail prices, in effect you take these goods into inventory at prices 
lower than their cost to you. So the markdown period has to bear an 
extra loss, and I just don't see it as a loss. All you're doing is preserving 
this 'fictional' standard, average markup on all goods, even those marked 
down, because you mark them down to a base low enough for you to do 
that on the marked-down price. It doesn't make sense. If you're going to 
sell an article for more than it cost you, but for less than you expected, 
why write its cost down (in a period before you sell it) just so you can 
make the expected percentage? If I were a buyer, I wouldn't mark things 
down in any reporting period if I wasn't sure, absolutely sure, that they 
would be sold in that period, because if they weren't, I'd be cutting my 
gross margin by absorbing unrealized inventory 'losses' that aren't losses 
at all!" 

"Our argument there is that a marked-down article has depreciated, 
if it has had to be marked down, John. It will have depreciated to such 
a value as will allow us to achieve our standard markup on it. Why are 
you so concerned that this may be unrealized, as you put it? It's a loss, 
isn't it?" 

"No, Mr. Lynch, I don't think so. Not if the article is going to be sold 
for more than it cost you anyway. Something else bothers me, too. 
Wouldn't it be more realistic to deduct the markdowns from the markups, 
thus giving a net markup, and then calculate the cost complement from 
that. Is there any difference? I suppose there must be, but I'm not too sure 
what it is." 

"John, I think the best way for you to get to understand the difference 
is for you to work it all out. Use the figures you have, and see what 
you get." 

Required 

1. Using the data in Exhibits 1 and 2, complete Exhibits 3 and 4. Why is the 
departmental profit higher in 1960 than in 1959? 

2. Assuming that no journal entries had been made in the inventory, pur- 
chases, or sales accounts since July 31, 1959, prepare the necessary entries 
to record all transactions in the Men's Suits Department for the six months 
ended January 31, 1960. 

3. Make the necessary computations for the system suggested by John Cook 
in the next to last paragraph of the case. What reasons are there for the 
"difference" referred to by Mr. Lynch? 

4. From the buyer's point of view is the system used by Jordan Marsh a fair 
way to measure merchandising profits? 



156 Jordan Marsh Company (A) 

5. As John Cook, be prepared to advise your buyer as to the effect of the 
heavy markdowns he took in January 1960. How do the buyer's decisions on 
markups and markdowns affect the profits shown for his department in the 
current period? In succeeding periods? 



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EXHIBIT 4 



Departmental Operating Statement 

Six Months Ended January 31, 1960 

(Dollar figures in thousands) 

Buyer : Mr. Malherbe Department : Men's Suits 

Actual Dollars This Year Last Year 

1. Net sales $458.6 

2. Purchases and alterations $325.9 

3. Inventory reduction (addition) .... (10.3 ) 

4. Cost of sales $315.6 

5. Gross margin and %/ sales $143.0 31.2% 

6. Discounts and rebates $31.4 31.3 

7. Gross margin plus discounts .... $174.3 

8. Direct expense: Advertising $22.8 $ 18.9 

9. Direct expense: Buyers' salaries . . 8.9 8.8 

10. Direct expense: Sales' salaries ... 23.3 20.2 

11. Direct expense: Other 3.9 3.6 

12. Total direct expense and %/ sales . . $58.9 12.0% $ 51.5 11.2 

13. Controllable operating profit $122.8 

14. Prorated and other expense $53.7 $ 57.0 

15. Net operating profit 65.8 

Retail Dollars 

16. Beginning retail inventory $ 62.7 

17. Retail purchases 511.6 

18. Total 

19. Sales 

20. Markdowns - regular and %/ sales 

21. Markdowns - discount and %/ sales 

22. Ending retail inventory 

23. Inventory shortage and %/ sales . . . 

24. Total 



$574.3 




$458.6 




29.6 


6.5 


1.9 


0.4 


79.3 




4.9 


1.1 


$574.3 





160 



CASE 23 



Wade 
Processors, Inc. 







n March 3, 1958, the first units of production 
were completed at the plant of Wade Processors, 
Inc. The company had been incorporated early in January 1958, shortly 
after receiving approval of a patent application covering its proposed 
manufacturing process. The three founders immediately set about to 
make arrangements for leasing manufacturing space, acquiring equip- 
ment, establishing firm marketing commitments, procuring supplies, and 
hiring the small work force that would be needed to commence opera- 
tions. Thus, on March 1, the preliminary organization period was ter- 
minated, and Arthur and William Ross and Joseph Grossman began what 
they believed would be a long and successful manufacturing operation. 
Arthur and William Ross were graduates of a prominent Mid- 
western business school and had met Mr. Grossman, a research chemist 
and registered engineer, at a product development seminar shortly after 
their graduation in 1956. At the time of their first acquaintance, which 
lasted for the better part of the summer of 1956, the three men became 
interested in the possibilities of developing commercial markets for 
materials that had been, up to that time, considered to be primarily food 
wastes. Although nothing tangible was accomplished over that summer, 
the men agreed that they would be interested in pursuing the matter 
further. The Ross brothers were willing to secure financial backing for any 
project that had reasonable possibilities for success, and Grossman would 

161 



162 Wade Processors, Inc. 

explore the possibilities of developing a practical, commercial reclama- 
tion process. 

In due time, Grossman advised the brothers that he had found a pro- 
cedure for making at least two commercially marketable products from 
recoverable wastes. He felt that his process was unique and that he could 
secure patent approval for it. 

Accordingly, William Ross obtained capital investment commitments 
from several associates, and he and his brother each agreed to invest 
$25,000 in the new venture. Grossman was to be given 200 shares of 
stock ( $100 par ) in exchange for his development of the process and the 
costs that he had incurred. 

Although the manufacturing process was not complex, it did require 
a small amount of special equipment. Essentially, the process comprised 
cleaning the materials, and crushing, grinding, drying, and screening the 
ground powder. The screening process yielded two distinct grades of 
granular substance. The coarse grade, marketed as "Argamen," was sold 
as a filler for certain types of livestock feeds; in addition to having some 
small value as a food material, it also satisfied the coarse-bulk require- 
ments of the less active types of farm livestock. The finer grade was ac- 
ceptable as a base material in the manufacture of cheap abrasive com- 
pounds and, as such, found a ready market. 

Messrs. Ross and Mr. Grossman saw their sales expand rapidly between 
March 1 and the end of the year, and kept track of the costs of operation 
very carefully so that they could analyze the profitability of their busi- 
ness. The schedules that follow present a summary of the information 
that they accumulated between March 1 and December 31. From this 
information they wished to have a balance sheet and income statement 
prepared for 1958. Because of the different natures of the two products, 
they wished to have an inventory figure for each product rather than one 
summary inventory figure. They decided among themselves that the first- 
in-first-out (fifo) basis should be used for valuing inventory, but were 
interested to know what difference it would have made had they used 
the last-in-first-out (lifo) basis. 



EXHIBIT 1 



Contributions of Capital 



Contributed by 

William Ross 
Arthur Ross 
Joseph Grossman 
James W. Leonard 
Ames Dillavou 
Others 



Amount 



$25,000 
25,000 

* 

10,000 

5,000 

10,000 

$75,000 



Number of Shares 
Issued ($100 par) 

250 
250 
200 
100 
50 
100 
950 



♦Grossman's contribution was the development of the process. His total out- 
lays, including the cost of securing the patent, were approximately $14,500. All 
the stockholders agreed to issue stock with total par value greater than that 
amount to ''reward Grossman for his singular contribution to the activation of 
the business." 



EXHIBIT 2 



1958 Manufacturing Data— Quantities 



1. Purchases of Bulk Materials : 

March: 2,000 tons @ $.317/cwt August: 2,400 tons @ .285/cwt 

April: 2,300 tons @ .315/cwt September: 2,000 tons @ .294/cwt 

May: 2,600 tons @ .310/cwt October: 1,800 tons @ .295/cwt 

June: 3,100 tons @ .288/cwt November: 1,600 tons @ .296/cwt 

July: 3,700 tons @ .287/cwt December: 1,800 tons @ .298/cwt 

2. Bulk Materials Released to Process : 20,600 tons 

3. Production Yield : Tons 

Argamen 2,400 

Base granules 16,200 

Saleable waste 1,000 

Nonrecoverable waste 400 

20,000 



4. Distribution of Production : 

Argamen 

Sales (in hundred pounds). . . . 28,000 
Inventory, hundred pound 

units as of 12/31/58 20,000 

48,000 

Convert to tons ± 20 

Tons accounted for 2,400 



Base Granules S.W. N.R.W. 



216,000 



108,000 
324,000 

-r 20 
16,200 



18,000 


7,500 


2,000 
20,000 


500 
8,000 


* 20 


-r 20 



1,000 400 



163 



EXHIBIT 3 



Cash Disbursed and Expenses Incurred 
March 1 through December 31, 1958 



Items Balance 
Paid Owing 

Materials -bulk shipments $102,014 $36,630 

Manufacturing costs: 

Rental payments 31,500 

Indirect materials 32,012 

Wages (*) 37,086 

Power and water 4,120 

Heat 8,200 

Other expenditures: 

Cost of organizing 3,700 

Executive salaries 19,800 

Purchase price (installed) of new 

machinery 21,800 

Payments on used equipment 45,000 

Miscellaneous administrative 6,606 

Installation of used eqpt 14,830 

Payments on bank loan 15,000 

Packaging materials 3,746 

$345,414 $51,112 

♦Withholding taxes not to be considered. 
fSee Exhibit 5. 



Total Paid 
and Obligated 

$138,644 





31,500 


2,498 


34,510 


694 


37,780 


560 


4,680 


2,200 


10,400 


_ 


3,700 


- 


19,800 




21,800 


t 


t 


2,040 


8,646 




14,830 


- 


15,000 


6,490 


10,236 



$396,526 



EXHIBIT 4 



Cash Receipts and Amounts Due 
March 1 through December 31, 1958 



Received 



Sales of Argamen $177,850 

Sales of base granules 27,100 

Sales of waste 3,600 

William Ross 25,000 

Arthur G. Ross 20,000 

James Leonard 10,000 

Ames Dillavou 1,000 

Other investors 8,000 

Proceeds of bank note 79,200 

$351,750 



Due But Not 




Received to 12/31 


Total 


$25,150 


$203,000 


5,300 


32,400 




3,600 




25,000 


5,000 


25,000 




10,000 


4,000 


5,000 


2,000 


10,000 




79,200 



$41,450 



$393,200 



164 



EXHIBIT 5 



Other Information 



1. Supply of packaging materials on hand on 12/31 = $3,746. 

2. Selling prices: 

Argamen $7.25/cwt 

Base granules .15/cwt 

Saleable waste .20/cwt 

3. Depreciation of new machines on basis of 5-year life; used machines on 
10-year life; no salvage value anticipated. 

4. Lease terms: 5 years with option to renew with 10% increase in rental 

for another 5-year period. 

5. Bank loan: In terms of a loan arrangement concluded on 4/1/58, the com- 
pany sold a $90,000 face value note to the bank. The total period of the loan 
was three years; a $7,500 repayment was to be made each three months 
from the date of the loan. The bank's charge for this arrangement was a 
nominal rate of 4% for each year, on the total face value of the note. The net 
proceeds to the company were therefore $79,200 ($90,000 less 12% of 
$90,000). 

6. Financing of used equipment: Purchase price on 3/1/58 was $216,000. Pay- 
ing seller $15,000 quarterly for 4 1/4 years, starting on 6/1/58. Payment 
includes principal and interest. 

7. Production was planned so that machinery could be dismantled for cleaning 
during last week of December; there were no materials in process. 

8. Income tax was payable at 30% of the first $25,000 of reported profits, and 
52% of any excess. 



165 



CASE 24 



Pahala 

Sugar Plantation, Ltd. 



i 



n April 1961, Mr. Cecil Forbes, a wealthy Hawaiian 
business entrepreneur, had been approached by 
Pahala Sugar Plantation, Ltd., relative to the leasing of a large tract of 
land which had been in the Forbes family for many years. Pahala Sugar 
planned to use the land to increase the size of their present sugar cane 
plantation, and had offered to pay Mr. Forbes, "40 per cent of the gross 
operating profit from sugar sales reduced to a proportionate share based 
on the ratio of the number of acres leased from Forbes to the total num- 
ber of acres which Pahala operated." A meeting had been planned be- 
tween Mr. Katana, Pahala plantation manager, and Mr. Forbes for April 
17, 1961, at which time the final terms of the lease contract were to be 
negotiated. 

Mr. Forbes knew it was a common practice in the sugar cane industry 
to lease land based upon a percentage of operating profit, since the quality 
of the land was an important factor in producing profitable sugar cane, 
but he also knew that the term "operating profit" meant many things to 
many people. He was not satisfied that the phraseology used by Pahala 
was sufficiently definitive to assure him a fair return for the use of his 
land, and thus he wanted to be sure that the final lease agreement was 
stated in terms that would assure him of a fair compensation for the 
productivity of his land. He obtained Pahala's financial statements for 
the year ended December 31, 1960 (Exhibits 1 and 2) and certain sup- 

166 



Pahala Sugar Plantation, Ltd. 167 

plemental information (Exhibit 3), which he hoped would better pre- 
pare him for the forthcoming contract meeting. After a cursory examina- 
tion of these statements, he decided to confer with his personal ac- 
countant, Mr. Tene, about the interpretation of the statements and the 
terminology which should be used in the final lease contract. 



PAHALA HISTORY 

Pahala Sugar Plantation, Ltd., located near the city of Pahala on 
Hawaii, the largest island of the Hawaiian Island group, had been founded 
in 1810. Pahala had grown steadily until 1925, when its annual sales 
volume had leveled out at approximately one million dollars and fluctu- 
ated around that level until 1942. In 1942, due to the increased sugar 
needs brought about by World War II, Pahala expanded its sugar opera- 
tion and increased its gross sugar sales to 1.6 million dollars during the 
war years. Since 1946, sales revenue from sugar operations had grown 
slowly and had exceeded 1.8 million dollars in 1960. This sales volume 
made Pahala one of the smaller of the thirty sugar plantations in the state 
of Hawaii. 

As was typical of all sugar plantations, Pahala processed the sugar cane 
it raised into raw sugar which was then sent to the continental United 
States for refining. In 1960, Pahala had nearly 4,500 acres of land (ap- 
proximately 80 per cent of which was cultivated) under its control, with 
75 per cent of the land owned by Pahala and 25 per cent leased from the 
State of Hawaii or individual lessors. During 1960, Pahala had decided 
to expand its production of raw sugar in order to share in the increase 
in consumer demand for sugar and sugar products which was expected 
to take place in the decade of the 1960's. In light of this decision, Pahala 
approached Mr. Forbes with the intent of leasing nearly 1,200 acres of 
land bordering on that which Pahala currently owned and operated. 
Most of the land which Pahala leased was covered by ten- to twenty-year 
lease contracts as was common in the industry. 

CULTIVATION AND PROCESSING OF SUGAR CANE 

Sugar cane field operations consisted of three distinct types of work, 
all of which were carried out on a year-round basis thus providing steady 
employment for a given work force, in contrast with most other types of 
agricultural employment. 

The first type of activity was the preparation of raw virgin land for 
the initial planting of the sugar cane. This consisted of cutting trees and 
brush from the land, dynamiting and bulldozing rocks and lava deposits, 
leveling and turning the soil, and installing roads, central irrigation canals, 



168 Pahala Sugar Plantation, Ltd. 

and irrigation reservoirs. This activity had to be performed only once for 
any given tract of land, and thus Pahala only performed this activity dur- 
ing those years when new land was acquired for cultivation. During 1960, 
400 acres of new land had been so prepared at a cost of $46,780, as shown 
in the first part of Exhibit 3. Mr. Katana stated that these expenditures 
were typical and that the cost of preparing larger tracts of land would 
vary in proportion with their size. The 400 acres had been obtained to 
replace 423 acres of leased land which were worn out insofar as pro- 
ductive sugar cane operation was concerned. The lease on this worn-out 
land had not been renewed in 1960. The life of any field was considered 
to vary between twenty and thirty years, although the average life of a 
plantation lease was only fifteen years. Pahala could restore productivity 
to the worn-out land by allowing it to lie fallow (idle) for a period of 
several years, but this was not common for leased land, since the lease on 
such land could be allowed to run out, thus shifting the burden of re- 
vitalizing the land to the lessor. Even on owned land a high rate of turn- 
over existed, since Pahala's management felt it was wiser to sell a piece 
of productively low land rather than hold it fallow until it was ready for 
replanting. An abundant supply of virgin land was available for the 
growing of sugar cane and thus the productively worn-out land presented 
no real problem to Pahala's management. 

The second activity involved the planting of the sugar cane. Sugar 
cane was a perennial grass which grew from ten to twenty feet high 
and produced a mature grass crop from every twenty-two to twenty-four 
months. When the first stand of cane was cut, a second crop, called a 
ratoon crop, grew from the old-established root system without a new 
planting. This reproduction process would take place every two years 
indefinitely, but each successive ratoon crop was less productive in terms 
of juice produced. Because of this decreasing productivity, a new root 
system was planted from every eight to ten years depending upon the 
variety of cane which was being replaced. 

The planting of a new root system required that the old cane roots 
be dug up and that the field be reworked by deep plowing and furrowing. 
New irrigation ditches had to be dug, and the aluminum (or concrete) 
irrigation flumes had to be relaid to connect with the permanent irriga- 
tion canal. Once the field was prepared, a three-foot trough was dug in 
which the sugar cane seed was placed. The "seed" consisted of a two- 
to three-foot length of sugar cane stalk which had either been (1) cut 
from the cane of a previous crop, ( 2 ) developed in the experimental field 
by the agricultural methods research department, or ( 3 ) purchased from 
another sugar cane producer. The seed was then covered with earth and 
the field was flooded to start the germination process. The cost of plant- 
ing or replanting incurred during 1960 was itemized as shown in the sec- 
ond portion of Exhibit 3. This was the cost of planting the 400 acres of 



Pahala Sugar Plantation, Ltd. 169 

new land acquired, and the cost of replanting 50 acres of land which 
Mr. Katana felt had passed the point of optimum productivity. 

The final and most time-consuming activity performed by the field 
crew was that of the annual cultivation and maintenance of the growing 
sugar cane. The cane crop had to be cultivated frequently to destroy weed 
growth and to maintain good drainage and tillage. Pahala's research de- 
partment had found that excessive weed growth reduced the sugar con- 
tent of the cane substantially. In addition to cultivation, chemical her- 
bicides were used to control the growth of weeds, and other chemical 
agents were used to control various types of insect pests and crop dis- 
eases. In the past, red rot disease had destroyed whole fields of cane, 
and even now with improved disease and insect control, the sugar plan- 
tation was not free from the hazard of such pestilence. The threat of 
hurricanes was also a matter of concern to Mr. Katana because previous 
hurricanes had destroyed as much as from 60 to 70 per cent of the sugar 
cane in the field. 

Fertilization and irrigation in proper amounts were also crucial to the 
growth of a high-sugar content cane. Water was not only pumped from 
wells on the Pahala plantation, but was also purchased from mountain 
water supply sources during critical growing periods of the year. A lack 
of the proper supply of water could cut the sugar content of the crop 
in half. 

When the cane matured, it had to be harvested immediately because 
the sugar juice which had accumulated in the cane would deteriorate if 
it was allowed to stand in the field for any length of time. The harvesting 
process began when the field was "fired" (set on fire) to burn off the 
leaves and pithy upper portion of the cane. This did not damage the cane 
stalk itself. The cane was next cut at ground level and raked into piles. 
Men then pitched the stalks into trucks for transportation to the raw 
sugar mill. 

Because of the continuous growing season in Hawaii, it was possible 
through careful planning to plant, harvest, and refine the cane fairly regu- 
larly throughout the year. Thus, each year approximately one-half of the 
total area under cultivation would be harvested and a new ratoon crop 
would start to grow. In any one year, approximately 40 per cent of the 
field crew's time was spent in caring for the cane crop which was to be 
harvested the following year (2,127 acres planned for 1961 exclusive of 
any acreage expansion); 30 per cent was spent in cultivating the crop 
that was to be harvested in the current year ( 1,787 acres in 1969 ) ; and 
30 per cent was spent on the current year's harvesting operation. During 
1960, $592,522 was spent in cultivating, maintaining, and harvesting the 
sugar cane crop (see Exhibit 3). 

At the raw sugar mill, the cane was first washed, then passed through 
knives which shredded the cane and finally sent between sets of large 



170 Pahala Sugar Plantation, Ltd. 

rollers which crushed the cane, separating the juice from the stalk. The 
juice was then passed into a large heating pan, and lime was added to 
precipitate out certain solids thus clarifying the liquid. The fibrous cane 
material which remained after this process was referred to as "bagasse" 
and was used as fuel for the boilers at the sugar mill. During 1960, some 
of the bagasse had been sold commercially to be used in the production 
of fiber wallboard, and Mr. Katana stated that new uses for the product 
had recently been developed in the fields of paper-making and plastics 
manufacturing. It was his opinion that all the plantation's bagasse would 
soon be sold commercially and that hydroelectric power would replace 
the steam boilers in the plant. 

The sugar solution in the pan was heated slowly until 85 per cent of 
the water had been evaporated, at which time the sucrose (or sugar) 
began to crystallize. The solution was then put into a vacuum pan where 
the crystallization of the sucrose was completed, leaving blackstrap mo- 
lasses as a residue. The dark brown sugar crystals were then bagged and 
shipped to the continental United States for refining. 

The residual blackstrap molasses was used in the production of rum, 
commercial alcohol, safety glass, and certain molded resins. Sales of this 
product accounted for $97,980 income in 1960 (see Exhibit 2). Mr. 
Katana stated that a ready market existed for all the residual molasses 
that could be produced. 

One of the most important behind-the-scenes activities in the operation 
of a sugar cane plantation was that of research and development. Vari- 
eties or species of sugar cane would weaken and deteriorate with con- 
tinued use, and thus the agricultural research department was con- 
tinuously trying to breed new revitalized species of sugar cane. The 
department operated experimental plots where various species and cross- 
species were planted and observed. Moisture requirements, effect of 
fertilizers, weeds, and irrigation, sugar content, and other variables were 
carefully controlled and measured in the development of a new strain of 
cane. A new improved strain of cane would be developed, on the average, 
every two to three years, and would be used to replace previous varieties 
of cane as called for in the rotational field planting master plan. During 
1960, over one-half of the department's time had been devoted to the 
development of a new species of cane, number 60-1492. This cane had 
initially been planted on an experimental basis is late 1958. The expenses 
of the research department for 1960 amounted to $94,682. 

Required 

1. As Mr. Tene, the accountant, prepare a report for Mr. Forbes in which you 
recommend the lease terms and the terminology that should be used in the 



Pahala Sugar Plantation, Ltd, 171 

lease contract. Provide Mr. Forbes with a solid basis upon which the terms 
of your proposed lease contract could be justified to Mr. Katana. 

2. Upon what grounds could Mr. Katana object to the terms of your proposed 
lease? 

3. In your opinion, are the financial reports now used by the Pahala Planta- 
tion adequate for internal management? For reporting to stockholders? 

4. What major financial reporting problems do you believe the accounting 
officer of the Pahala Plantation, Ltd., faces in the sugar plantation opera- 
tions? 



EXHIBIT 1 



Balance Sheet, December 31, 1960 

Assets 

Current assets: 

Cash $ 5,460 

Accounts receivable: 

Advances to lessors $ 73,920 

Trade 11,113 85,033 

Inventory of supplies— at cost 76,390 

Total current assets $ 166,883 

Investments, at cost: 

C & H sugar refinery, 2,060 shares $ 410,000 

Other 38,600 

Total investments 448,600 

Property, plant, and equipment, at cost: 

Buildings $ 326,240 

Machinery and equipment 1,271,400 

Leasehold improvements 1,810 

Water system and reservoirs 147,900 

Roads, bridges, and fences 282,300 

Other 65,775 

$2,095,425 

Less: Reserve for depreciation and amortization . . 1,215,305 

$ 880,120 

Land 275,080 

Total property, plant, and equipment 1,155,200 

Prepaid expenses 24,417 

Total assets $1,795,100 



Liabilities and Capital 

Current liabilities: 

Accounts payable— trade 

Notes payable, due within one year 

Accrued liabilities: 

Cane purchases, balance due cane growers . . 

Payroll & salaries 

Federal income tax , 

State income tax 

Other 

Total current liabilities $ 316,970 

Long term debt: 

5% note due Hilo City Bank 185,000 

Capital shares and surplus: 

Common stock, no par, authorized and issued 

400,000 shares 400,000 

Reinvested earnings at use in the business 893,130 

Total liabilities and capital $1,795,100 



$ 


68,760 
15,000 


$ 22,100 

82,860 

102,400 

10,600 




15,250 


233,210 



172 



EXHIBIT 2 



Statement of Income for the Year Ended 
December 31, 1960 



Gross income from sugar sales $1,812,750 

(15,100 tons sugar @ average price of 
$120 per ton, harvested from 1,787 acres) 

Less operating expenses: 

Cost of cane accumulated prior to its delivery 

to the mill yard.* $944,680 

Manufacturing costs (including mill yard 

operations and raw sugar production)* 292,110 

Employee servicing costs (Pension costs, 
vacation payments, payroll taxes, health & 

life insurance, etc.) 110,240 

Marketing expenses 271,300 

General and administrative expenses* 198,525 

Total operating expenses $1,816,855 

Gross operating profit (loss) $ (4,105) 

Other income: 

Dividends from security investments $ 20,400 

Gross income from sale of molasses 

(5,500 tons molasses @ average price of 

$17.50 per ton, residue from 15,100 tons of 

sugar) 97,980 

Gross income from sale of bagasse 

(Represented 1/10 of total annual residual 

bagasse) 7,358 

Conditional payment on prior years crop under 

provisions of the Sugar Act. f 134,625 

Profit from sale of real property 4,390 

Other 3,800 

Total other income 268,553 

Other expenses: 

Loss on obsolete property $ 2,878 

Interest on notes and other indebtedness 12,185 

Loss on sale of securities 1,685 

Other 16,300 

Total other expenses $ 33,048 



Net income before income taxes $ 231,400 

Provision for federal and state income tax .... 113,000 

Net profit after tax for 1960 $ 118,400 



*See Exhibit 3 for an analysis of this expense. 

t Subject to the conditional payment provisions of the Sugar Act of 1948, hav- 
ing been complied with relative to restrictive production quotas for the year 
1960, a payment on the sugar production for the year of approximately $130,000 
should be received from the Secretary of Agriculture in 1961. Payment in the 
amount of $134,625 covering the 1959 year was received and credited to income 
in the 1960 statement of income. Mr. Katana felt this payment could be justified 
as " other income," since it was a contingent payment made only if assigned 
government production quotas were not exceeded. Pahala's planned expansion 
was not expected to violate these quotas. 



173 



EXHIBIT 3 



Detailed Cost Analysis of Various Cost Accounts 



Cost of Cane Accumulated Prior to its Delivery to the Mill Yard 

Original field preparation: 

Clearing $ 8,760 

Plowing and required blasting , . . 14,320 

Road preparation 7,500 

Preparation of the irrigation system 16,200 

Total outlay for field preparation in 1960 $ 46,780 

Planting and/ or replanting of cane: 

Plowing $ 4,774 

Planting 13,198 

Replanting plant 3,250 

Cost of seed cane 19,310 

Placement of irrigation flumes 8,300 

Total outlay for cane planting in 1960 48,832 

Cultivation and maintenance of growing crops: 
Ratooning: 

Preparing ratoons $ 8,621 

Replanting ratoons 24,162 

Seed cane 13,394 $ 46,177 

Weed control: 

Herbicide weed control $ 42,742 

Herbicides used 63,680 

Hand weeding 2,620 

Mechanical cultivating 1,313 110,355 

Fertilizing: 

Fertilizer used $ 62,462 

Airplane fertilizing 6,521 

Mechanical fertilizing 71,080 140,063 

Irrigation: 

Preparation of irrigation system ... $ 13,275 

Irrigation 46,219 

Water supply system 30,010 

Maintenance of system 3,700 93,204 

Miscellaneous cultivation expenses . . . 12,163 

Total cultivation and maintenance of 

growing crops for 1960 401,962 

Miscellaneous charges: 

Agriculture and methods research department ..... $ 94,682 
Road maintenance 32,180 

Harvesting and transporting cane: 

Mechanical harvesting $ 45,530 

Field transportation 42,210 

Trucking of cane to mill 102,820 $190,560 

Field rental 38,000 

(cont'd) 



174 



EXHIBIT 3, cont'd 



Cost of cane purchased from other growers 
to be processed in Pahala's mills— 
in lieu of field rental payments. 
(Fields under Pahala's control 
under special agreement) $ 70,284 

Miscellaneous services, e.g. garage, 
maintenance shop, quarry, and civil 

engineering 21,400 

Total miscellaneous charges $447,106 

Total cost of cane accumulated 

prior to the milling operation $944,680 



Manufacturing Costs 

General factory cost $ 44,102 

Mill yard 25,340 

Cleaning plant 20,085 

Crushing plant 38,820 

Fireroom 34,210 

Boiling house and laboratory 84,674 

Off-season repairs 44,879 

Total manufacturing costs-1960 $292,110 



General and Administrative Expenses 

Plantation administrative $ 34,975 

Accounting 41,290 

Warehousing 21,010 

Industrial engineering 5,500 

Industrial relations 8,743 

Other administrative 61,545 

Hauling labor— hired 7,252 

Housing and village servicing 2,530 

Medical clinic 15,680 

Total general and administrative- 19 60 $198,525 



175 



CASE 25 



Rocky Mountain 
Construction Company 



E 



arly in February 1960, during a meeting of the 
board of directors of the Rocky Mountain Con- 
struction Company, located in Boulder, Colorado, Mr. Benthall, president 
and chief operating officer, expressed his concern over an operating state- 
ment which had been presented at the meeting (see Exhibit 1). A 
discussion of this statement ensued in which several of the directors and 
officers present took opposing views concerning the proper presentation 
of income for the land development department of the company. The 
company's statements were not only used by management for evaluation 
of company operations, but were also sent to the company's stockholders. 
Furthermore, Mr. Benthall realized that the company's statements were 
going to be presented to the public or to a commercial bank in the near 
future in order to raise the capital necessitated by the company's recent 
expansion into the field of land development. 

Because of the confusion and uncertainty created at the board meeting 
and because of the importance of the financial statements, Mr. Benthall 
contacted Mr. Reardon, a member of the staff of a large management 
consulting firm located in Denver, Colorado. He asked Mr. Reardon to 
evaluate each of the opposing viewpoints presented at the board meeting 
and to recommend to him the best method of preparing the statement 
under discussion. He then explained to Mr. Reardon the events which 
had led up to his present request. 

176 



Rocky Mountain Construction Company 177 



COMPANY BACKGROUND 

Mr. Benthall and his two sons had incorporated the Rocky Mountain 
Construction Company in 1946 as a small masonry and general home 
improvements construction organization located in Boulder, Colorado. 
The company had grown rapidly during its first few years and had ex- 
panded its operations into residential home construction and small in- 
dustrial plant construction. As additional financing became necessary, Mr. 
Benthall had sold stock to several local Boulder businessmen, but he and 
his sons retained ownership of 65 per cent of the stock and desired to 
maintain a controlling interest in the company if possible. However, the 
need for cash was so pressing that Mr. Benthall and his sons had agreed 
to a public stock offering, if this was the only alternative. The company's 
net profits before taxes had been in excess of $50,000 every year since 
1951, and had reached $70,000 for the year ending December 31, 1958. 
The company was expecting annual profits of $75,000 from its construc- 
tion operations during the next few years. 

Up until 1959, the company had primarily built private homes, and had 
constructed small manufacturing plants in the Boulder-Denver area. The 
industrial growth of Boulder was quite rapid between 1946 and 1958, and 
continued rapid growth of this area was expected. The population of 
Boulder, located thirty miles from Denver via a turnpike, had increased 
from 20,000 in 1950 to close to 40,000 in 1958, and the number of in- 
dustrial plants in the city had increased over 400 per cent. Many national 
companies had indicated their interest in building local branch plants 
and offices in Boulder because of its ideal geographical location and 
pleasant living conditions at the foot of the Rocky Mountains. 

In late 1958, Mr. Benthall and his sons decided that the development 
of an industrial park in Boulder would probably be a profitable venture 
in view of the area's growth expectations. After consulting with local 
real estate agencies, they decided that the purchase of fully improved, 
subdivided land would be economically unsound, and therefore decided 
to establish a land development department in the company which was 
to develop raw land into plots suitable for industrial plant construction. 
If this operation proved to be profitable, they planned further industrial 
land development undertakings of this same nature in the Denver- 
Boulder area. 

The company purchased a tract of land, 2,768,709 square feet, adjoin- 
ing Route 119, a major highway leading into Boulder, and began planning 
Boulder Industrial Park. They hired an accountant to maintain all finan- 
cial records and act as office manager for the new department with the 
responsibility of carrying out the plans indicated by Mr. Benthall. 



178 Rocky Mountain Construction Company 



BOULDER INDUSTRIAL PARK 

In mid-December 1958, a purchase price of $500,000 for the land was 
agreed upon, and an architect was hired to draw up plans for the pro- 
posed industrial park ( see Exhibit 2 ) . Legal fees, title transfer fees, and 
title insurance premiums of $3,909, were also expended on the project 
at that time. 

During 1959, the company began to develop the raw farm land into 
tracts suitable for the construction of industrial plants. Some of the work 
was performed by the land development department itself, and other 
phases of the work were subcontracted to specialists. 

After the initial phase of surveying and laying corner markers, general 
excavation was started. The land was first cleared of trees, brush, rocks, 
and old farm buildings, and in some spots, geological deposits of peat 
moss had to be removed and filled with gravel or other solid fill. Grading 
or leveling was the second step in the land improvement program. Next 
came the installation of temporary haul roads and storm ditches or drains. 
Once this work had been completed, permanent access roads, storm 
drains, sewers, and water mains were installed in the industrial park. 
As of December 31, 1959, certain of these operations had been fully com- 
pleted, whereas others were only partially completed. Nearly $300,000 
had been spent on these operations during 1959. Exhibit 3 lists the total 
improvement costs incurred as of December 31, 1959, for each of the 
major land development phases, and indicates the required cost to com- 
plete each improvement phase as estimated by the individual project or 
operation superintendent or contractor. The first column (labor) listed 
the labor cost of those operations performed directly by the land de- 
velopment department itself, whereas the second column ( invoice ) listed 
not only the cost of materials, but also the cost of that work which had 
been subcontracted. This column also included the charge for equipment 
rental as determined by the company's construction department. The 
land development department owned no heavy equipment and thus in- 
curred no depreciation on its books. Instead, all equipment was owned 
and maintained by the construction department which charged a flat 
rental rate to the land development department for the use of all equip- 
ment. These charges amounted to $30,000 in 1959. The third column 
accumulated the total cost of land improvement to December 31, 1959. 
The last three columns listed the estimated costs of completing this land 
development project. 

Two parcels of land were completed and disposed of during 1959 ( as 
indicated in Exhibit 4). One was sold to an industrial organization for 
plant construction, and the other was transferred to the construction 



Rocky Mountain Construction Company 179 

department for construction of a plant which would then be sold or 
leased by the company to an industrial concern desiring to locate in the 
Boulder area. 

In order to summarize the operations for the year 1959, Mr. Rabit, 
accountant and office manager of the land development department, 
prepared an operating statement ( reproduced as Exhibit 1 ) for the land 
development department and presented it to Mr. Benthall and the board 
of directors for approval at their February meeting. It was because of the 
ensuing discussion that Mr. Benthall felt he had to consult with Mr. 
Reardon in order to clear up the confusion created at the meeting. 



GENERAL MEETING OF ROCKY MOUNTAINS BOARD OF DIRECTORS 



mr. benthall: Our next item of business is the profit and loss statement of 
the land development department as prepared by Mr. Rabit, the depart- 
ment's accountant [Exhibit 1]. As we expected, the department showed a 
large operating loss for the year 1959 due to the large outlay for land and 
initial land development costs which were incurred during the first year. 
However, I'm quite concerned over the prospect of combining this depart- 
ment's $73,000 loss with the construction department's 1959 profit of 
$68,000, thus disclosing a net loss for the year of $5,000. Not only will 
our present shareholders be quite concerned over this loss, but the prob- 
ability of floating a new stock issue or of obtaining a bank loan would be 
substantially reduced by the presentation of such a statement. As you 
know, I have already come under fire because of my decision to enter the 
land development business, and the picture this statement presents would 
certainly add fuel to the fire. 

frank reed [Director of Rocky Mountain and Owner of (Ledgewood) 
Realty Co.]: Roy [Mr. Benthall], I think we need to take a really close 
look at Mr. Rabit's statement. I, for one, don't agree with his method of 
presenting the land development department's results for 1959. He seems 
to have forgotten that the department has a large inventory of partially 
improved plots on hand as of the end of the year; yet he has deducted 
from sales income the total cost of the entire tract and all the land de- 
velopment costs to date. Some of this should be deferred as the cost of 
land that is still available for sale. In my opinion, Mr. Rabit has prepared 
a very misleading and incorrect statement of the department's profit for 
1959, and if certain land costs are deferred, the department will show a 
profit rather than a loss for 1959. 

bill collins [Rocky Mountain stockholder]: Now Frank, hold on just a 
minute. The statement that Mr. Rabit prepared is an honest presentation 
of the cash flow that took place in the department in 1959. It is essentially 
a cash statement, with certain normal accruals and deferrals, that es- 
sentially shows how the company's funds were derived and used in 1959. 
It serves its purpose and should be useful to management in its cash 
budgeting program. 

mr. benthall: This may be so, Bill, but the statement still doesn't lend itself 
to obtaining outside financing. I think Frank had a good idea when he 
said that certain of these costs could be deferred until future periods of 



180 Rocky Mountain Construction Company 

time, but two points about his approach bother me. First, what happens 
to these deferred costs if our expected future sales don't materialize? We 
might not sell all those plots for two or three years yet, even though we 
have spent the money. And second, how do you propose to allocate the 
total land costs to the plots which were sold? I'm sure that Mr. Rabit 
didn't keep track of the costs by individual plots, and as you know the 
plots are at various stages of completion. 

james hickman [Director of Rocky Mountain and Vice President of Construc- 
tion Contracting]: Roy, I think that Frank is making a mistake when he 
only looks at individual plots. I think we should consider the Park as a 
complete entity in itself, and recognize income from it based on the per- 
centage of completion method used in our construction operation. From 
the figures Mr. Rabit gave you [Exhibit 3], you can estimate the completed 
cost of the development. You could also estimate the total income which 
you expect to receive from the development based on sales to date. Then 
the profit recognized this year would be the percentage of estimated total 
profit that incurred costs to date bear to estimated total costs. And further- 
more, such a statement would show a higher profit than the one which 
Frank proposes, and thus the earnings per share figure this year would 
reflect the true profit which the company earned during the year. This 
would end some of the unfavorable criticism which several of our share- 
holders expressed when we went into the land development business and 
would provide a healthy income statement which could be used to float 
a stock issue or obtain a bank loan. This method would also eliminate the 
necessity of trying to assign costs to individual plots, and would answer 
Roy's question about deferred costs. 

mr. benthall: Jim, I like your idea of the high earnings figure. . . . 

frank reed: Now just a second, Roy! Don't let Jim confuse you by his slip- 
pery methods of pulling a big profit out of the clear blue! That land hasn't 
been sold yet, and you can't recognize profit on your inventory just be- 
cause you would like to have a pretty income statement. The only profit 
we are entitled to show is that profit which we made on actual sales dur- 
ing 1959. Why, Jim's method would have us showing income this year on 
plots which may not be sold for two years! That just isn't good accounting. 
And not only that, but think of the additional income tax you would have 
to pay under his method. You would be paying tax this year on cash 
income which you wouldn't be receiving until next year or the year after. 

bill collins: You're right, Frank, that Jim's method would show a higher 
profit figure, but it is not allowed by the tax authorities. The tax code 
clearly specifies the method of accounting that land development com- 
panies are required to use in statement preparation, thus leaving us little 
leeway in preparing our published statements. The Prentice-Hall Tax 
Guide, paragraph 10,163, states, "The cost should be equitably ap- 
portioned to the several lots, and gain or loss calculated on each lot sold. 
This rule implies that there will be an individual gain or loss on every lot 
sold and not that the taxpayer shall wait until the capital on the entire tract 
has been recovered through sales receipts before any taxable income is to 
be returned. Development costs, including future development costs, may 
be included in computing gain or loss on sale of lots. Cost apportionment 
must be made equitably and not ratably, for example, on market price 
rather than on a square-foot basis, since front lots would ordinarily bear 
a greater portion of the cost than those in the rear of the development." 

bob allen [Director of Rocky Mountain and Executive Vice President of the 



Rocky Mountain Construction Company 181 

First National Bank of Boulder] : You are probably right on the tax regula- 
tions, Bill, but that doesn't mean we have to prepare our published state- 
ments in accordance with the tax code. We can prepare them in any 
manner we desire, and I can't agree with you, Jim, or with the tax code, 
Bill, when you propose a recognition of profits which may never mate- 
rialize. Your methods assume that all the land will eventually be sold, and 
at a profit. However, I think Jim started out on the right track when he 
said you had to look at the Park as one complete entity, not as nine 
separate units. I don't think you should show any profit until you have 
fully recovered all your costs, because in reality, you plain just don't make 
a profit on this development until you have sold enough land to recover 
all your costs! Then the rest is gravy. I think that all income and all 
expense from the development should be deferred until the entire project 
is finished and then you can decide how much profit you made. You aren't 
grabbing in the dark for estimated this and estimated that, as your method 
does Jim. You know, for a fact, exactly how much you made on the 
project. This is the method my bank uses in recasting submitted corporate 
statements since it doesn't want to loan money to a company on the basis 
of unearned profits which may never be realized. As you know Roy, there 
is considerable risk that actual future costs will not be the same as the 
estimated costs, and this is particularly true in the construction business, 
and heaven only knows how far off your estimated sales prices might be! 

Cameron benthall [Mr. Benthall's eldest son and Executive Vice President 
of Rocky Mountain]: I agree with you Bob, except that I think only the 
difference between the sales income and the land costs incurred should 
be deferred until future periods. This would mean that a deferred income 
or a deferred expense account would be carried until the entire Park was 
completed, at which time you would then recognize your actual profit or 
loss. We wouldn't be jumping to any conclusions in recognizing profits 
which we didn't make. 

bradley benthall [Mr. Benthall's youngest son and General Construction 
Manager]: I can't agree with you or Bob, Cam; you're being too con- 
servative. Your method would show no profit for two or three years, and 
our chance of floating a stock issue would be nil if we presented such a 
statement to prospective stockholders. I think a combination of methods is 
what we really need. I agree with Bill when he says we must recognize 
the profit we made on the plots which were sold in 1959. The land costs 
could be allocated to these plots on the basis of square footage, expected 
market price, front footage on an access street, or any other reasonable 
basis. Further, I think that these plots should also bear some portion of 
the general operating expenses which will be incurred during the next 
two years, the time we anticipate it will take to completely dispose of all 
the plots. It seems likely to me that these expenses will remain relatively 
constant during the life of the development, regardless of the percentage of 
completion or degree of sales saturation. Finally, I think estimated profit 
should be recognized on those plots which are held under a sales option 
contract or intended for use by the construction department. It appears 
likely that these options will be taken up, since land prices are constantly 
increasing. All costs not allocated to the plots sold in 1959, or under 
option, should be deferred until future years. This method would provide 
the most realistic reporting of earnings. The consistent use of this method 
will provide our stockholders and potential investors with stable revenue 
and earnings figures on which year-to-year operating comparisons can be 



182 Rocky Mountain Construction Company 

based. I think this is something we should consider before we choose a 
method of reporting income. 
mr. benthall: It seems to me that the objective of a good income statement 
should be to match costs and revenues during a given period of time and 
only then can the true profitability of a firm be judged. I am not sure 
which of your proposed methods would do this, so I suggest we adjourn 
until such time as I can gather together the results which would be 
reported under each of your methods. We will then meet and discuss the 
merits of each one and decide at that time which one best fulfills our 
needs relative to internal reporting, external reporting, and tax reporting. 



Required 

1. What income would be reported under each of the proposed methods and 
which method should Mr. Reardon recommend to Mr. Benthall? Why? 

2. Should administrative, general, and selling expenses be treated as costs of 
the current year, or should they be treated as other land development costs? 



EXHIBIT 1 



Land Development Department 
Profit and Loss Statement for the Year Ending 



December 31, 1959 



Sales revenue: 



Plot number Amount received 
1 $632,000 
3 158,945 
Total sales revenue $790,945 

Other income : 

Purchase option on Plot No. 9 5,000 

Total income for period $795,945 

Less cost of sales: 

Original purchase price of land $500,000 

Land development costs to 

Dec. 31, 1959 (see Exhibit 3) 299,564 

Total land costs 799,564 

Gross profit or (loss) on sales : $ (3,619) 

Operating expenses :* 

Advertising $ 475 

Commissions to outside brokers 665 

Park dedication and press conferences ... 1,140 

Purchase of signs and office equipment . . . 6,226 

Inspection fees 928 

Legal and accounting 7,850 

(includes legal fee, title fee, and 

insurance premium incurred on original 

land purchase) 

Photographs and renderings 2,113 

Salaries— salesmen 12,695 

Salaries- office 6,620 

Salaries— engineering 3,113 

Salaries— General Manager, Land Department 10,000 

Sales commissions 3,480 

Taxes 5,315 

Direct operating expense $ 60,620 

Operating expense allocated from the 

construction department! 8,533 

Total operating expense 69,153 

Net loss for year ending December 31, 1959 $ 72,772 

*A11 operating expenses have been computed on an accrual basis and thus in- 
clude not only cash expenditures made during 1959 but also include those ex- 
penses due but not paid as of December 31, 1959. These costs were incurred 
directly by the land development department. 

t Allocated on the basis of each department's total sales revenue. This in- 
cludes heat, light, and power, rent on the office building, telephone and telegraph, 
and other joint expenses. 



183 





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184 



EXHIBIT 3 



Land Development Department 
Part 1— Improvement Costs to December 31, 1959 



Account Classification Actual Cost to Date Estimated to Finish 

Labor Invoice Total Labor Invoice Total 

500 SITE WORK * 

8 Pile driving 

10 Temporary lights 

11 Clearing 

12 Unclassified excavation 

13 Earth excavation 

14 Peat excavation 

15 Rock excavation 

16 Temporary storm ditches 

17 Temporary site work 

18 Temporary (haul) roads 

19 Gravel borrow 

Total 

520 ROADS 

21 Unclassified excavation 

22 Earth excavation 

23 Peat excavation 

24 Rock excavation 

25 Gravel borrow 

26 Finish roadwork— subcontracted 
30 Granite curbing 

32 Loam, spread, & seed 

33 Maintenance 

Total 

540 STORM DRAINS 

40 10" R.C. pipe 

41 18" R.C. pipe 

42 24" R.C. pipe 

43 Manholes, including castings 

44 Catchbasins 

46 21" R.C. pipe 

47 15" R.C. pipe 

48 30" R.C. pipe 

Total 

550 SEWERAGE 

50 8" sewer 

51 10" sewer 

52 Forced main 

53 Manholes, including castings 

54 Adjust to line & grade 

55 Pumping station 

56 Maintenance of utilities 

57 12" sewer 

58 Exploration for 10" 

Total 6,209 25,092 31,301 14,913 44,482 59,395 

560 WATER MAINS 



2,406 


9,037 


11,443 








769 


709 


1,478 








34 


101 


135 








536 


8,131 


8,667 








9,208 


19,060 


28,268 








2,351 


32,493 


34,844 








15,304 


69,531 


84,835 


-0- 


-0- 


-0- 


1,037 


2,736 


3,773 








2,034 


4,908 


6,942 








68 


4,050 


4,118 








2,319 


35,680 


37,999 








677 


15,229 


15,906 


562 


32,438 


33,000 


49 


37 


86 








795 


4,914 


5,709 








985 


965 


1,950 


2,400 


3,290 


5,690 


293 


311 


604 








8,257 


68,830 


77,087 


2,962 


35,728 


38,690 


2,511 


2,882 


5,393 








305 


1,051 


1,356 








1,122 


3,723 


4,845 








1,004 


1,150 


2,154 








2,085 


1,749 


3,834 








32 


62 


94 


11,320 


16,860 


28,180 


339 


1,544 


1,883 








864 


3,605 


4,469 








8,262 


15,766 


24,028 


11,320 


16,860 


28,180 


1,209 


5,731 


6,940 








1,907 


14,371 


16,278 


8,617 


17,682 


26,299 


2,607 


3,448 


6,055 








94 




94 




22,680 


22,680 


392 




392 


2,436 




2,436 




1,542 


1,542 


3,860 


4,120 


7,980 



61 10" C.I. pipe 


2,567 


19,463 


22,030 


3,110 


30,245 


33,355 


62 12" C.I. pipe 




295 


295 




4,820 


4,820 


63 Hydrants 


125 


230 


355 


6,500 


15,977 


22,477 


64 8" C.I. pipe 


1,072 


3,689 


4,761 


3,700 


7,400 


11,100 


Total 


3,764 


23,677 


27,441 


13,310 


58,442 


71,752 


570 OPEN DRAINAGE DITCH 


5,609 


28,706 


34,315 


-0- 


-0- 


-0- 


580 ENGINEERING 


2,204 


6,508 


8,712 


620 


1,416 


2,036 


590 INDIRECT GENERAL 














CONDITIONS 


5,942 


5,903 


11,845 


4,812 


6,237 


11,049 


GRAND TOTALSt 


55,551 


244,013 


299,564 


47,937 


163,165 


211,102 



♦Includes site work chargeable directly to specific plots. See Part 2 for detail, 
t Includes field supervision, watchman's salary, temporary toilets, rain gear, and field 
telephone. 

(cont'd) 



185 



EXHIBIT 3, cont'd 



Part 2 — Site Work Chargeable Directly 
to Specific Plots 



Cost Classification 



Plot 


Total 

Site 

Work 


511 


514 


515 


519 


Number 


Labor 


Invoice 


Labor 


Invoice 


Labor 


Invoice 


Labor 


Invoice 


1 


25,840 




3,012 


536 


896 


3,740 


6,579 


307 


10,770 


3 


17,069 








2,741 


4,313 


5,820 


979 


3,216 


5 


10,466 








3,500 


800 


420 


586 


5,160 


9 


13,911 








_ 


944 


355 


6,241 


479 


5,842 


Totals 


67,286 





3,012 


536 


8,131 


9,208 


19,060 


2,351 


24,988 



Note : Charges under classifications 511,514, and 519 were for the removal of peat and 
dumping of gravel fill on specific plots which were not suitable for construction in raw 
form. Classification 519 accumulated the cost of blasting and removing a rock shelf which 
cropped up under certain plots. 



186 



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187 



CASE 26 



Amos Carholtz 
Distillery, Inc. 



E 



arly in August 1961, Mr. David Carholtz, president 
and chief operating executive of Amos Carholtz 
Distillery, Inc., of Oakwoods, Tennessee, sat in his office pondering the 
results of the previous day's meeting of the board of directors. He was 
wondering whether or not he should submit the 1961 financial statements 
(Exhibits 1 and 2) to the Ridgeview National Bank of Nashville, Ten- 
nessee, in support of a recent loan request for $1.5 million, or whether 
he should wait until next month's board meeting in the hope of obtaining 
clarification of some of the preceding day's discussion. A great deal of 
controversy had arisen over the reported loss of $169,000 in 1961 and 
how this result should be reported to the bank. The controversy seemed 
to resolve principally around the accounting treatment of various ex- 
penses reported in the "other costs" section of the operating statement 
and around the question of what assets should be classified as current 
assets. Mr. Carholtz knew that a decision had to be reached on these 
matters quickly, for the company had reached a point where additional 
working capital was needed immediately if the company was to remain 
solvent. 

188 



Amos Carholtz Distillery, Inc. 189 



COMPANY HISTORY 

Amos Carholtz began distilling whiskey in 1880. Amos had come to 
Oakwoods, Tennessee, from Germany the preceding year and had de- 
cided to carry on in the family tradition of beverage manufacture. He 
purchased a tract of land on a high knoll adjacent to a small stream fed 
by a limestone spring and began to distill bourbon whiskey in an old 
barn behind his home. His business grew from a trickling in 1880 to a 
million dollar firm by 1911. He attributed this growth to the high-quality, 
distinctive bourbon whiskey which he produced. The quality of "Old 
Trailridge," Carholtz's only brand of whiskey, was claimed to be the 
result of the unusual iron-free spring water used in the distillation process 
and the aging process which took place in specially prepared fire-charred 
white oak barrels. 

From 1911 to 1933, the years of prohibition in Tennessee, the distilling 
equipment lay dormant, and it was not until late 1934 that the company 
began to operate once again in a newly constructed building. Sales rose 
from $500,000 in 1935 to nearly $5 million in 1941, when the plant was 
converted to defense production of commercial alcohol. 

In 1946, Mr. David Carholtz, grandson of Amos, took over as chief 
operating executive of the company. Under David Carholtz sales revenue 
doubled between 1946 and 1961 (see Exhibit 3). Mr. Carholtz felt that 
the company had grown because of the stress it placed on marketing a 
distinctive, high-quality, high-price product and because of its concen- 
tration on one brand of fine bourbon whiskey, Old Trailridge. The com- 
pany's advertising stressed the uniqueness of the cool, bubbling spring 
water used in the distillation of Old Trailridge and pointed to its use 
of "specially prepared and cured fire-charred white oak barrels." David 
Carholtz thought this type of promotion had been very effective in estab- 
lishing a brand image of Old Trailridge in the consumer's mind that 
conveyed a concept of full-bodied mellowness, camaraderie, and old- 
fashioned, backwoods quality. 

In 1960, the company produced approximately 1.5 per cent of the 
whiskey distilled in the United States and thus was one of the smaller 
distillers in the industry. Previously, no special effort had been made 
to gain a larger share of the market; but at a board meeting in December 
1960, a decision had been made to expand production to try to capture 
a larger than proportionate share of the increase in whiskey consumption 
which Mr. Carholtz had forecast, based on an industry research report. 
This report showed that the consumption of straight bourbon whiskey 
had increased ( at the expense of blended whiskeys ) from 15 per cent of 
total whiskey consumption in 1947 to nearly 50 per cent of total con- 
sumption in 1959. Based on this report and other industry forecasts, Mr. 



190 Amos Carholtz Distillery, Inc. 

Carholtz had forecast a doubling of straight whiskey consumption from 
1960 to 1968. In view of this, and because bourbon whiskey had to be 
aged for at least four years, the board had decided to increase the 
production of whiskey in 1961 by 50 per cent of the 1960 volume (see 
Exhibit 2 ) , in order to meet the anticipated increase in consumer demand 
for straight bourbon whiskey from 1964-1968. 



THE MANUFACTURING PROCESS 

Old Trailridge was a straight bourbon whiskey and thus, by law, had 
to be made from a mixture of grains containing at least 51 per cent corn 
and had to be aged in new (not re-used) charred white oak barrels. The 
process began when the ground corn was mixed with pure limestone 
spring water in a large vat. To this mixture was added a certain amount 
of ground barley-malt and rye. It was then heated slowly until the 
starches were converted to sugars, thus completing the "mashing" process. 
This mash was then pumped into a cypress fermenting vat where yeast 
and certain other ingredients were added. This mixture was allowed to 
ferment for several days until the yeast had converted the sugars into 
alcohol, at which time the fermenting process was complete and the 
mash was pumped into a distillation tower (or still) where the alcohol 
was separated from the "slurry," or spent mash, through a series of 
distillation tanks and condensers. The distilled liquid was then mixed 
with limestone spring water to obtain the desired proof (per cent of 
alcohol by volume where one degree of proof equals one-half of 1 per 
cent of alcohol). At this point the whiskey was a clear liquid with a 
sharp, biting taste and had to be mellowed before consumption. For this 
process, it was pumped into fifty-gallon barrels and moved to an aging 
warehouse. The cost accumulated in the product prior to its entry into 
barrels was approximately $.50 per gallon (see Exhibit 2). 

MATURING OR AGING PROCESS 

In order to mellow the whiskey, improve its taste, and give it a rich 
amber color, the new bourbon whiskey had to be matured or aged for 
a period of time of not less than four years ( and often five or six years ) 
under controlled temperature and humidity conditions. The new whiskey 
reacted with the charred oak and assimilated some of the flavor and 
color of the fire-charred oak during the period of aging. 

Since the quality of the aging barrel was an important factor in de- 
termining the ultimate taste and character of the final product, Carholtz 
had his fifty-gallon barrels manufactured under a unique patented process 
at a cost of approximately $30 per barrel. The barrels could not be re-used 



Amos Carholtz Distillery, Inc. 191 

for aging future batches of bourbon whiskey but could be sold to used- 
barrel dealers for $.50 each at the end of the aging period. 

The filled barrels were next placed in open "ricks" in an aging ware- 
house, rented by Carholtz, or in part of the factory which had been con- 
verted into warehousing space ( see Exhibit 4 ) . The increased production 
in 1961 necessitated the leasing of an additional warehouse at an annual 
rental cost of $100,000. The temperature and humidity of the warehouse 
space had to be controlled since the quality of the whiskey could be 
ruined by aging too fast or too slow, a process determined by temperature 
and humidity conditions. 

Every six months the barrels had to be rotated from a high rick to a 
lower rick or vice versa (because of uneven temperatures at different 
locations in the warehouse), and sampled for quality and character up 
to that point in the aging process. A small amount of liquid was removed 
from representative barrels at this time and sent to the sampling labo- 
ratory for quality inspection (usually performed by skilled tasters). If 
the quality of the whiskey was not up to standard, certain measures 
were taken, such as adjusting the aging process, to bring it up to standard. 
At this same time, each barrel was also checked for leaks or seepage, and 
the required repairs were made. 

At the end of the four- to six-year aging period, the barrels were 
removed from the ricks and dumped into regauge tanks where the charred 
oak residue was filtered out and volume was measured ( see Exhibit 4 ) . 
On the average, the volume of liquid in a barrel declined by 30 per 
cent during the aging period because of evaporation and leakage. Thus 
a barrel originally filled with fifty gallons of new bourbon would, on 
the whole, produce only thirty-five gallons of aged bourbon. The regauge 
operation was supervised by a government liquor tax agent, since it was 
at this point that Federal excise tax of $10.50 per gallon was levied on 
the whiskey removed from the warehouse. Once the bourbon had been 
removed from the aging warehouse, it was bottled and shipped to whole- 
salers with the greatest speed possible because of the large amount of 
cash tied up in taxes on the finished product. 

EXCERPTS FROM BOARD OF DIRECTORS MEETING, AUGUST 3, 1961 

mr. carholtz: Gentlemen, I'm quite concerned over the prospect of obtaining 
the $1.5 million loan we need in light of our 1961 loss of $169,000. We 
have shown annual profits since 1948 and on much smaller sales volumes 
than we had this year. In fact, our net sales of $21.7 million this year is 
the largest in our entire history and yet we incurred a net loss for the 
year. I think I understand the reason for this, but I'm afraid that the loan 
officers at the Ridgeview National Bank will hesitate in granting us a loan 
on the basis of our most recent performance. It appears that we are be- 
coming less efficient in our production operation. 



192 Amos Carholtz Distillery, Inc. 

mr. james doud [Production Manager]: That's not so, David. You know as 
well as I do, that we increased production by 50 per cent this year and with 
this increased production, our costs are bound to increase. You can't 
produce something for nothing. 

mr. Robert Thompson [Controller]: Well, that's not quite so, Jim. Granted 
that our production costs must rise when production increases, but our 
inventory account takes care of the increased costs by deferring these 
product costs until a future period when the product is actually sold. As 
you can see by looking at our 1961 profit and loss statement, our produc- 
tion costs only increased by $56,000 and that represents the cost of our 
increased sales. The largest share of the increase in production costs has 
been deferred until future periods as you can see by looking at the in- 
crease in our inventory account of nearly half a million dollars. I believe 
that the real reason for our loss this year was the large increase in other 
costs composed chiefly of warehousing costs. 

mr. carholtz: Well, what's your explanation for the large increase in the 
warehousing costs, Jim? 

mr. james doud: As I said before, Dave, we increased production and this 
also means an increase in warehousing costs since the increased produc- 
tion has to be aged for several years. You just can't age 50 per cent more 
whiskey for the same amount of money. 

mr. carholtz: But I thought Bob said that increased production costs were 
taken care of in the inventory account. Isn't that so, Bob? 

mr. Robert Thompson: Well, yes and no, David. The inventory account can 
only be charged with those costs associated with the direct production of 
whiskey, and our warehousing costs are handling or carrying costs, cer- 
tainly not production costs. 

mr. james doud: Now just a minute, Bob, I think that some of those costs are 
just as valid production costs as are the direct labor and materials going 
into the distillation of the new bourbon. The manufacturing process doesn't 
stop with the newly produced bourbon; why it isn't even marketable in 
that form. Aging is an absolutely essential part of the manufacturing 
process, and I think the cost of barrels and part of the warehouse labor 
should be treated as direct costs of the product. 

mr. carholtz: Great, Jim! I agree with you that warehousing and aging costs 
are an absolutely essential ingredient of our final product. We certainly 
couldn't market the bourbon before it had been aged. I think that all the 
costs associated with aging the product should be charged to the inventory 
account. I think that most of the "other costs" should be considered a cost 
of the product. Don't you agree, Bob? 

mr. Robert Thompson: Sure, Dave! Let's capitalize depreciation, interest ex- 
penses, your salary, the shareholders' dividends, our advertising costs, 
your secretary's salary— why, let's capitalize all our costs! That way we 
can show a huge inventory balance and small expenses! I'm sure Ridge- 
view and the Internal Revenue boys would be happy to cooperate with 
us on it! Why we'll revolutionize the accounting profession! 

mr. carholtz: Now cool down, Bob. Be reasonable about this. I'm afraid I 
really don't see why we couldn't charge all of those costs you mentioned 
to the inventory account; it seems to me that they are all necessary in- 
gredients in producing our final product. What distinction do you draw 
between these so called "direct" costs you mentioned and the aging costs? 

mr. Robert Thompson: By direct costs I mean those costs that are necessary 
to convert raw materials into the whiskey that goes into the aging barrels. 



Amos Carholtz Distillery, Inc. 193 

This is our cost of approximately $.50 per gallon and includes the cost of 
raw materials going into the product such as grain, yeast, and malt; the 
direct labor necessary to convert these materials into whiskey; and the cost 
of any other overhead items that are needed to permit the workers to 
convert grain into whiskey. I don't see how aging costs can be included 
under this generally accepted accounting definition of the inventory cost 
of the finished product. 

mr. daniel mouts [Executive Vice President of a large Nashville stock- 
brokerage firm]: Not to change the subject, Bob, but I don't see that 
we're getting anywhere on this inventory question on its own merits. In 
another light, Jim's proposal of increasing the value of the inventory ac- 
count, has an advantage relative to our balance-sheet ratios. By increas- 
ing the value of our inventory account we will thereby also increase our 
current assets, and this would certainly be to our advantage in securing 
the loan. Our ratio of current assets to current liabilities is less than 4 to 1, 
whereas the industry average, on the whole, is approximately 9 to 1, and 
our ratio of current assets to total liabilities is only 1.5 to 1, whereas the 
industry average is nearer 2.5 to 1. Not only that, but our long-term debt 
would greatly exceed our equity if the proposed loan were added to our 
present balance sheet. It seems to me that a deferral of some of the 
aging costs to the inventory account would definitely improve our credit 
picture by increasing both our current assets and our equity base. 

mr. carholtz: Now I really am confused! What do you mean by current 
assets? I thought that current assets consisted of cash and certain other 
assets that could readily be converted into cash in the near future, gen- 
erally one year, but our aging costs certainly don't meet that definition and 
I'm not sure that our inventory account would fall under this classifica- 
tion either. 

mr. Robert Thompson: That used to be the concept of current assets, Dave, 
but more recently the American Institute of Certified Public Accountants 
stated that current assets are composed of "cash and other assets or 
resources commonly identified as those which are reasonably expected to 
be realized in cash or sold or consumed during the normal operating cycle 
of the business." It is obvious that our inventory balance would fall under 
this definition, and generally accepted accounting principles recognize 
that inventory balances are current assets. 

mr. carholtz: Well, it may be obvious to you, Bob, but it certainly isn't 
obvious to me! Dan, why is this current asset classification so all-fired 
important to you brokers and to the bankers? What does it show you 
anyway? 

mr. daniel mouts: Well, Dave, bankers use the current ratio to help them 
judge whether or not the business requesting a loan will generate enough 
cash to make the loan repayments on their due dates. Very simply, it tells 
them whether or not the company is going to be able to meet its current 
obligations and still have enough left to repay the bank on the loan 
and .... 

mr. carholtz: But, Dan, that's inconsistent! My inventory won't generate 
cash for several years, and it certainly won't be liquidated before it is 
aged. Even though part of our inventory is bottled and sold each year, an 
even greater quantity is produced and placed in the warehouses. You can't 
judge whether or not we'd be able to repay our loan by looking at our 
inventory account. Why, you'd be better off to look at our depreciation 
charges each year. What we're really liquidating is our fixed assets— 



194 Amos Carholtz Distillery, Inc. 

liquidating in the sense that we're using them to produce whiskey which 
is ultimately sold for cash. Actually, the balance we show for fixed assets 
is decreasing every year, as the inventory stays constant or increases. 
What it seems to boil down to is that the so-called fixed assets are really 
current and that the current assets are fixed! One of us is certainly con- 
fused on the meaning of current assets! 

I think we'd better defer further discussion of this entire subject until 
our meeting next month. In the meantime I am going to try to get this 
thing squared away in my own mind. I have never really thought that 
financial statements had much meaning, but now I am not at all sure that 
they aren't truly misleading documents! 

Well, let's turn next to the question of . . . 



Required 

1. What effect would Mr. Doud's suggestion, of charging certain warehousing 
costs to the inventory account (or Mr. Carholtz's statement that all such 
costs should be capitalized), have on the 1961 financial statements? 

2. Would you recommend that Mr. Carholtz use this method of accounting in 
preparing the annual financial statements which were to be submitted to 
Ridgeview National Bank? 

3. Prepare a short report for Mr. Carholtz which will help him understand the 
current vs. fixed assets concept. Comment on his statement that, "fixed 
assets are really current, and current assets are fixed." 



EXHIBIT 1 



Balance Sheet as of June 30, 1960 and 1961 
(All figures in thousands) 



I960 1961 

Current Assets 

Cash $ 1,274 $ 316 

Accounts receivable-trade (less allowance for doubt- 
ful accounts of approximately $165,000) 2,875 3,221 

Inventories: 

Bulk whiskey in barrels at average production 

cost (no excise tax included) 3,218 3,710 

Cased goods and in process, at lower of average 

cost or market (including excise tax) 1,910 2,000 

Raw materials and supplies 400 236 

Prepaid expenses 441 389 

Total current assets $10,118 $ 9,872 



Fixed Assets 



Assets 
Cash surrender value of 

officers' life insurance 

Land 

Building* 1,910 

Factory equipment . . 
Warehouse equipment . 

Trade- marks and brands . . 8 8 8 8 1,237 1,394 

Total assets $11,355 $11,266 

Current Liabilities 
Notes payable: 

Short-term to banks $ 1,100 $ 1,500 

Current maturities of long-term debt 230 245 

Accounts payable 860 419 

Accrued liabilities 199 115 

Provision for federal taxes on earnings * 410 

Total current liabilities $ 2,799 $ 2,279 

Noncurrent Liabilities 

Notes payable (5 1/2%) secured by deed of 
trust on warehouse property (less 
current maturities of $230,000 for 
1960 and $245,000 for 1961) . . 3,500 4,100 

Stockholders' Equity 

Common stock held principally by members 

of the Carholtz family 1,800 1,800 

Earnings retained in the business 3,256 3,087 

Total liabilities and capital $11,355 $11,266 

♦In June 1961, payment was made for work which had been performed during the year in 
adding to and improving the warehousing space in the building owned by Carholtz Distillers. 



Accumulated 




Cost Depreciation 
1960 1961 1960 1961 


Net 
1960 1961 


e 

$ 30 $ 30 


$ 32 $ 35 
30 30 


1,910 2,110 $800 $853 
72 72 26 38 


1,110 1,257 
46 34 


35 64 24 34 


11 30 


8 8 


8 8 



195 



EXHIBIT 2 



Statement of Income for the Years Ended 

June 30, 1960 and 1961 

(All values in thousands) 



Net Sales : 1960 1961 

Sale of whiskey to wholesalers. The sale of bottled whiskey in 1960 
and 1961 respectively was equivalent to the sale of 43,000 and 
44,500 barrels of whiskey. Because of leakage, evaporation 
and spillage, on the average, 30% of the bulk stock was lost 
between the date of production and the date of bottling. There- 
fore, a barrel contained only about 35 gallons of aged whiskey 
at the time of bottling $21,004 $21,700 

Cost of Goods Sold : 

Federal excise taxes— on whiskey sold 15,685 16,238 

Cost of product charged to sales: 

Bulk whiskey inventory July 1, of respective year 

(125,000 and 127,000 barrels) $3,230 $3,218 

Plus: Cost of whiskey produced to inventory (included 
direct and indirect materials and labor consumed 
in the production process. Produced 43,000 barrels 
at an average cost of $25.60/50 gallon barrel in 
1960 and 63,000 barrels in 1961 at an average cost 

of $26.20/50 gallon barrel) 1,090 1,650 

$4,320 $4,868 

Less: Bulk whiskey inventory June 30, of respective 
year (127,000 and 144,000 barrels at average 

production cost) $3,218 1,102 $3,710 1,158 

Cased goods and in process July 1 of respective year . . $2,050 $1,910 

Cased goods and in process June 30 of respective year . . 1,910 140 2,000 (90) 

Other Costs Charged to Cost of Goods Sold : 

Cost of barrels purchased during year (45,000 barrels 

@ $31.00 per barrel and 64,000 barrels @ $31.50 

per barrel) $1,400 $2,020 

Depreciation on building (one-half of building used for 

storage of barreled whiskey) 53 53 

Rent on adjacent building used for whiskey storage* ... 70 170 

Labor cost of warehousemen and warehouse supervisor 97 167 

Heat, light, power (rented warehouse) 28 49 

Heat, light, power (owned building) 51 53 

Miscellaneous maintenance and supplies expense incurred 

by warehousing operation 31 57 

Labor and supplies expense of chemical laboratory .... 68 83 

Insurance on owned building 16 22 

Insurance on rented warehouse(s) 7 21 

Taxes on building 13 21 

Depreciation on factory equipment 12 12 

Depreciation on warehouse equipment 6 10 

Cost of government supervision and bonding facilities . . 3 7 

Cost of bottling liquor (labor, glass, and miscellaneous 

supplies) 210 2,065 193 2,938 

Total cost of goods sold— respective years .... " $18,992 $20,244 

Gross profit from operations 2,012 1,456 

Less: Selling and advertising expenses $ 910 $1,161 

Administrative and general expenses! 350 1,260 464 1,625 

Net profit (loss) before tax $ 752 $ (169) 

Less: Income tax 290 

Net profit (loss) after tax $ 462 $ (169 ) 

♦The increase in production in 1961 necessitated the rental of additional warehouse space. 
fThe increase in this expense from 1960 to 1961 was principally caused by increased interest payments 
on the additional notes payable issued in 1961 to help finance the increase in production. 



196 



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198 



CASE 27 



Beale 
Company 



E 



arly in November 1955, the new president of the 
Beale Company was eagerly awaiting comple- 
tion of the profit and loss statement for October. He knew that October 
sales had exceeded those for September by more than $50,000, and he 
was anxious to see how much of this increased sales volume was re- 
flected as extra profit. But when the report came in, it showed an over-all 
loss of $5,015 ( Exhibit 1 ) as compared with a September profit of $3,509. 
The president immediately thought some mistake had been made and 
called in the controller for an explanation. The controller said the figures 
were correct, but that in October the company had not produced any- 
where near its normal volume and hence the charge for unabsorbed 
burden had decreased the profit more than the added sales had increased 
it. He said that if the rate of sales were always the same as the rate of 
factory production, the kind of distortion that was bothering the president 
would not appear. However, when the factory operations were out of 
phase with sales operations, such distortions were almost certain to result 
as long as the company followed the commonly practiced accounting 
convention of charging or crediting periodic over- or under-absorbed 
factory overhead to the current profit and loss account. 

The president reacted strongly to the controller's explanations: "I don't 
care a hoot for your accounting conventions. But I do know this: when 
our sales go up, with other things reasonably equal, I am going to expect 

199 



200 Beale Company 

my profit to show an increase. If your reports cant show so simple a 
thing as that, why do we spend so much money on your department?" 

As a matter of fact, the controller had been thinking about much the 
same problem that disturbed the president, but from a slightly different 
angle. Accordingly, he seized the opportunity to propose a radically 
different approach to the problem of overhead: charge the fixed overhead 
costs for the month to the current operating statement in a lump sum 
just as is commonly done in the case of selling and administrative ex- 
penses. Thus there would be no problem of heavy over- or under- 
absorbed overhead as the volume of operations changed. Cost of Goods 
Sold, of course, now would reflect only the nonfixed factory costs, that 
is, variable costs, which the controller called "direct costs." 

As an illustration, the controller reworked the company's figures for 
October, with the startling result that the former loss of $5,015 was 
turned into a profit of $11,028 (Exhibit 2). When this figure was shown 
to the president he first exclaimed, "That's more like it." Then he hesitated 
and started to speculate: "But this means more taxes and more demands 
for wage increases and dividends and what-all. Maybe your idea isn't 
so good after all." 

The controller was in favor of the new plan largely because of its 
simplified accounting procedures. For one thing, there would be no fixed 
overhead costs in the standard cost figures for different products but 
only the three classes of "direct costs": 

(a) The cost of raw materials; 

(b) Direct labor; 

(c) The portion of the outlay for manufacturing expenses which varied 
directly or closely in proportion to productive activity. 

Omission of fixed overhead costs from the individual product costs would 
mean that the vexing and expensive task of working out an acceptable 
allocation of overhead to each product would be unnecessary. Inasmuch 
as many of these prorations had in fact become out of date, the con- 
troller was further attracted to his plan by the possibility that the ex- 
pense of the needed overhauling of the figures might be avoided. 

The controller also believed the proposed system would greatly sharpen 
the focus of management on the controllable portion of costs by spot- 
lighting the variable elements. Standards for the variable costs incurred 
by the different departments at different levels of output could be worked 
out by engineering methods. Since the fixed costs pertaining to factory 
operations tend to fall into quite a different category from that of the 
variable costs, they should be segregated anyway. By way of analogy 
he suggested that, like a retail store, a manufacturing company "pur- 
chases" its product for a known "direct cost." Consequently, the chief 
difference between the two kinds of business is that to make a profit the 



Beale Company 201 

manufacturing company has to pay the fixed factory costs in addition 
to the selling salaries, administration costs, storage, and so on. Further- 
more, the fixed factory costs are like the occupancy costs (rent, main- 
tenance, and so on ) of a retail store. On such a basis the factory's "direct 
costs," that is, variable costs, are similar to the retail store's "cost of 
pur chases. " 

The controller argued that a further advantage of his proposal would 
be the provision of a more satisfactory basis for making the usual monthly 
comparison of margin figures in the company's product-by-product Gross 
Margin Statement. When recast in the new form (with fixed costs ex- 
cluded), the figures would be much more meaningful than at present. 
The new margin figures would be, of course, much higher all down the 
line, but once the management adjusted its thinking to the new basis, 
the controller was confident that the value of knowing how much each 
product was contributing to fixed costs and profit would be greatly 
appreciated. 

One of the sales executives supported the controller's argument on the 
usefulness of the new margin figures. He pointed out, for example, that 
if there were two products sold by one of his divisions, Products A and 
B, and if the situation were as described in the following example, Prod- 
uct B, in general, would clearly appear to be the more desirable item 
to sell. 

Total Factory Cost Per Cent of 

Product per Pound (std.) Selling Price Margin Sales 

A $ .897 $1.55 $ .653 42.1 

B 1.015 1.80 .785 43.6 

But if the new margin figures were to work out something as follows, 
then Product A was by all odds the product on which the company's 
selling effort really should be concentrated: 

Variable New Per Cent of 

Product Factory Cost Selling Price "Margin" Sales 

A $ .413 $1.55 $1,137 73.6 

B .809 1.80 .991 55.6 

The controller's proposed method of keeping records, the sales executive 
reasoned, would thus reveal the true opportunities for profit. He cited 
one company he knew that had so redirected its selling effort that in 
less than eight months it had shifted from an operating loss to an operat- 
ing profit and had maintained good profits ever since. 

At this point in the discussion, the treasurer entered the argument. He 
observed cynically that if the example cited was typical of the Beale 
Company, the first thing anyone knew, the sales department in its ef- 
forts to get business would be selling at its usual markup over the new 
standard cost figures (variable costs only). "When that time comes," he 



202 Beale Company 

snorted, "how are we going to cover the fixed costs? Where do w T e get 
our capital replacements? We'll have to pay the piper sooner or later." 

Turning to the controller, who had talked of the desired focus of the 
new system of variable costs, the treasurer gave as his opinion, based 
on long experience, that it was the lack of control of the long-run costs 
that really wrecked a company. "You can make mistakes on the direct 
costs," he said, "but because things in this area are constantly changing 
and because one never makes much of a commitment anyway, the life 
of the company is really not prejudiced. If necessary, a new manage- 
ment can quickly reverse the trend. But once a company lets the long-run 
costs get out of control, then the fat really is in the fire. I'm opposed 
to anything that leads us to take a short-sighted view of cost." To this 
argument the controller had little to say, except that it was a matter of 
emphasis, and that he still thought the variable costs the most im- 
portant. 1 

All the group discussing the proposal were aware of the effect of the 
controllers scheme on the inventory item in the balance sheet. The 
treasurer, and the president too, were worried about this effect, and 
both wondered if the possible improvement to the operating statement 
was worth the price of distorting the balance sheet. The controller 
proposed that a footnote be carried in the balance sheet calling attention 
to the matter, and perhaps indicating the extent of the distortion. Bal- 
ance sheets by the company are shown in Exhibit 3, together with an 
indication of how the balance sheet figures would appear had the com- 
pany used the "direct cost" method. Income statements for September, 
under both the present and proposed methods are shown in Exhibit 4. 
On this exhibit, nomenclature and arrangement have been changed some- 
what in order to facilitate comparison between the present and proposed 
systems. 

When one of the officials asked about the Federal income tax implica- 
tions, the controller pointed out that the tax return was a special report, 
that it already differed from the company's operating reports in several 
respects, and that the reports he was suggesting were monthly profit 
estimates largely for internal use and not annual reports. Furthermore, 
if the company wished to do so, the annual reports could be computed 
on the more orthodox basis. "But," he insisted, "let's make these monthly 
reports so that they help us, not handicap us." 



Required 

1. What do you recommend? 

2. What would be the effects of the controller's proposal on the balance sheet? 



1 Variable costs were 67 per cent of total costs in 1954. 



Beale Company 203 

3. Approximately how busy (relative to normal volume) was the factory in 
October? 

4. Could the problem in the case ever arise with respect to annual statements 
of profit? 



EXHIBIT 1 



Condensed Income Statement 
Month of October, 1955 



Sales $336,903 

Cost of sales at standard 178,168 

Gross margin above standard costs 

Less manufacturing variances 

Labor $ 4,321 : 

Material 3,972 

Overhead 

Volume 26,870 

Spending 1,347 

Gross profit 

Selling costs: 

Selling expenses $ 84,514 

Sales taxes 3,236 

Freight allowed 7,195 

Total selling costs 

Operating profit before administration costs . . 

Administration costs: 

General administrative expenses $ 20,640 

Research expenses 5,879 

Total administration costs 

Operating profit 

Other income or charges 

Loss , current month 

*Credit variance. 



$158,735 



27,868 
$130,867 



$ 35,922 



26,519 
$ 9,403 



5,015 



EXHIBIT 2 



Condensed Income Statement (proposed style) 
Month of October, 1955 



Sales 

Standard "variable" cost of sales 

Gross margin above variable costs . . . 

Selling expenses: 

Selling expenses 

Sales taxes 

Freight allowed 

Total selling expenses 

Merchandising margin 

Administrative expenses: 

General administrative expenses 

Research expenses 

Total 

Additional factory expenses: 

Fixed factory overhead 

Manufacturing variances: 

Labor variance 4,3 2V 

Material variance 3,972 

Overhead variance (spending) 1,347 

Operating margin 

Other income or charges 

Profit, current month 

♦Credit variance. 



$336,903 
123,133 



$ 84,514 
3,236 
7,195 



$ 20,640 
5,879 



$ 65,862 



998 



$213,770 



94,945 
$118,825 



26,519 



66,860 
25,446 
14,418 

11,028 



204 



EXHIBIT 3 



Condensed Balance Sheets as Actually Prepared 



Assets 



As of 
September 30, 1955 



Current Assets 

Cash $ 80,560 

Accounts receivable 150,428 

Inventory 573,630 

Total current assets 804,618 

Plant and equipment (net) 2,120,450 

Total assets $2,925,068 

Liabilities and Net Worth 

Current liabilities $ 397,480 

Mortgage payable 560,000 

Total liabilities $ 957,480 

Net worth 

Capital stock 1,000,000 

Retained earnings 967,588 

Total net worth $1,967,588 

Total liabilities and net worth $2,925,068 

Effect of ''Direct Cost" Method 



As of 
October 31, 1955 



$ 95,553 
178,610 
521,822 


795,985 
2,108,788 


$2,904,773 


$ 382,200 
560,000 


$ 942,200 

1,000,000 
962,573 


$1,962,573 


$2,904,773 



Had the Beale Company used the direct cost method, its balance sheets would appear as 
above except for the Inventory and Retained Earnings items. These would appear as below: 

As of As of 

September 30, 1955 October 31, 1955 



Inventory $ 401,541 

Retained earnings $ 795,499 



$ 365,776 
$ 806,527 



Note : In both present and proposed statements, the effect of income taxes is shown. The 
Beale Company recorded estimated income tax expense only at the end of the calendar year. 



EXHIBIT 4 



Condensed Income Statement 
Month of September 1955 

As 
Actually 
Prepared 

Sales $283,028 

Cost of sales at standard 152,604 

Gross margin $130,424 

Less manufacturing variances 

Labor 5,426* 

Material 5,081 

Overhead 

Volume 447* 

Spending 2,173 

Fixed factory overhead — 

Subtotal overhead and variances $ 1,381 

Profit before administrative & selling expenses $129,043 

Selling expenses (total) $ 85,482 

Administrative expenses (total) 26,026 

Total administrative & selling expenses $111,508 

Operating profit $ 17,535 

Other income charges 14,026 

Net profit or loss current month $ 3,509 



-Under 
Proposed 
Method 

$283,028 

104,662 

$178,366 

5,426* 
5,081 



2,173 

65,862 

$ 67 ; 690 

$110,676 

$ 85,482 

26,026 

$111,508 

($ 832) 

14,026 

($ 14,858) 



♦Credit variance. 



205 



CASE 28 



The Bayard 
Nail Company 



The Bayard Nail Company, dating back to 1875, 
produced nails, findings, blacking, polish, and 
cement for the shoe manufacturing industry during most of the period 
from 1900-1930. However, by 1956, the company operated only a nail 
factory in Worcester, Massachusetts, producing several lines of nails, with 
about 50 per cent of sales going to the shoe trade. In 1956, the owner- 
president, Mr. Bayard, sold the firm with its machinery, equipment, and 
inventories to a group of investors led by Mr. Steel. Mr. Bayard retained 
ownership of the building and land but granted the new owners a five- 
year lease and an option to buy at less than appraised value. 

Mr. Steel, prior to his purchase of Bayard, had served as a director of 
American Shoe Distributors and some other organizations in which he 
had invested. American Shoe Distributors had been organized a few years 
earlier to distribute various supplies to the shoe manufacturing industry, 
following the antitrust action against United Shoe Machinery Corpora- 
tion which restrained the latter corporation's distributing activities. Mr. 
Steel's belief that American Shoe Distributors needed a dependable supply 
of nails had led to his purchase of Bayard. In addition to Mr. Steel, the 
following persons invested in and assumed management responsibility 
at Bayard: Mr. Richards, a partner in a Boston public accounting firm; 
Mr. Adams, a former production engineer for a Mussachusetts shoe-nail, 

206 



The Bayard Nail Company 207 

manufacturer; and Mr. Johnson, formerly plant superintendent for an- 
other shoe-nail manufacturer. 



OPERATIONS-FIRST FISCAL YEAR 

Most of the funds provided by the new owner-managers were used to 
pay Mr. Bayard, so an arrangement was made with a large Boston bank 
to extend credit to Bayard up to 75 per cent of their accounts receivables 
other than those from American Shoe Distributors. Credit was not ex- 
tended against the American account ( representing 50 per cent of Bayard's 
sales and receivables) because the bank was not satisfied with financial 
and operating figures at American. 

In the Fall of 1956, immediately after the new management took con- 
trol, the company was faced with several adverse developments: a slump 
in demand for nails with intense competition holding prices down, in- 
creased raw material costs, and inefficiencies in production caused by 
changes in methods. During the subsequent winter, when orders in- 
creased, production could not be expanded quickly enough to take full 
advantage of the larger volume. 

During this early period detailed financial statements were not avail- 
able, but management believed that they were operating at a slight loss. 
Several months after closing the books at the end of the third quarter 
on May 31, 1957, operating statements became available indicating a loss 
of about $10,000. This was not considered serious because of the ab- 
normal market conditions. However, cash was tight and payables were 
long overdue. 

In November 1957, audited statements became available for the first 
year of operation ending, August 31, 1957, and indicated to management 
surprisingly poor operations. Mr. Richards had believed the loss would 
be much lower because he had overestimated ending inventory (see 
Exhibits land 2). 

Mr. Richards re-examined his earlier statements to check on what ap- 
peared to be a disastrous fourth quarter. He decided that about $15,000 
was actually lost during the fourth quarter rather than the $75,000 in- 
dicated by the statements. To account for the poor operating results he 
prepared a statement of analysis of losses (Exhibit 3) in which he at- 
tributed much of the losses to nonrecurring expenses. 

During the first year of operations additional capital had been raised 
to pay Mr. Bayard the final installments on the purchase price of the 
company. These funds were obtained ( a ) through a $35,000 subordinated 
loan from the officers, (b) through a ten-year, 6 per cent loan from the 
SBA for $60,000, secured by all machinery and equipment and requiring 
monthly amortization, (c) by pledging their foreign tack inventory to a 



208 The Bayard Nail Company 

local bank which allowed credit up to % of cost if stored in public ware- 
houses, and ( d ) by selling an additional $80,000 worth of common stock. 
In September 1957, the competitive situation permitted an increase in 
prices of about 7 per cent and, since operating costs had been reduced 
slightly, Mr. Richards believed they were operating at about the break- 
even point and that the worst was over. The Boston bank, while con- 
cerned over the operating results of the first year, had high regard for 
Bayard's management and were willing to maintain their loan agreement. 

PRODUCTS 

There were four major product categories within the Bayard line of 
nails. Over 1000 different combinations of heads, sizes, points and other 
variables existed in each line. The major category was nails for shoe 
manufacturing and repair businesses and represented about 50 per cent 
of total sales. These nails were used chiefly to fasten rubber and leather 
heels in shoe construction and repair. A second category was building and 
construction nails. Although large steel companies produced most com- 
mon building nails, 15 per cent of Bayard's sales came from special pur- 
pose nails, such as flooring and masonry nails. About 15 per cent of sales 
came from industrial specialties representing nails for construction of 
boxes, pallets, beer cases, and pins and clips for general fastening pur- 
poses. About 20 per cent of sales came from assorted nails distributed 
through variety chains, supermarkets, and hardware stores. 

Competition existed in the form of many large and small, domestic and 
foreign, nail-making firms, but no one firm competed seriously in all lines. 
For example, the large volume, common building nails produced by 
Bethlehem Steel Company and American Steel and Wire Company were 
not in direct conflict with Bayard's specialties. However, there were many 
smaller firms producing some of the types of nails produced by Bayard. 
A final form of competition was represented by other fastening methods, 
such as adhesives, which were used in sole fastening where nails were 
formerly used. There was a common belief in the shoe business that 
eventually adhesives could be developed for heel attachment purposes. 

PRODUCTION 

Special forms of the steel wire nail were the basis of all Bayard produc- 
tion. Production originated in the nail making department where steel 
wire was forced through a die for about %", flattened to form a head, 
then passed on through for the length of the nail and cut and pointed. 
This operation was performed on many small automatic machines requir- 
ing tenders only to load wire and to adjust and oil machines. The rough 



The Bayard Nail Company 209 

nails were then tumbled in hardwood sawdust and cleaning solution to 
deburr, polish and degrease. Cleaned nails were then inspected and 
packed, unless they required a finishing operation, such as rolling, plating, 
or coating. Since August 1956 the nail making machines had worked an 
average of 40 per cent of full three-shift capacity, and the other depart- 
ments had worked 1-2 shifts. 

The plant consisted of five floors, the lower four of which were used 
for manufacturing. Production began with the movement of wire from 
storage in the basement to nail machines in the basement or at the ends 
of the first floor. The tumbling department was located in the center of 
the first floor, the finishing operations on the first four floors and packing 
on the first three floors. Finished production was stored on all five floors. 
Although all the machines were old, they operated much the same as 
new models. 

All orders received by the sales office were recorded on a shipping copy 
which was sent directly to the shipping office if the order was for stocked 
items. Nonstock orders were copied into a production order and a ship- 
ping order. All production orders were handled by Mr. Adams, who 
made out a cutting order specifying the wire to be used, the type and 
quantity of nails to be produced as well as the machine and operator to 
cut the nail. Mr. Adams assigned the work on the basis of the nail's 
complexity, and the nail maker's skill, workload and experience. From 
the cutting order a clerk made out a group of production cards for the 
order— one card for each tote box (75 lbs) needed to fill the order. 
These cards carried the same information as the cutting order with an 
additional section specifying routing to secondary operations, if any. 

The production cards were given to the nail maker as the work assign- 
ment. The nail maker ordered wire from the stock room and tools from 
the tool room for the job. The cutting order was placed on a "control 
board" arranged by nail machine. This board provided a running record 
of orders in the plant and their stages of completion— as each tote box 
was filled, a stub from its production card was sent to the production 
office and posted on the control board. When the tote box was packed 
and sent to shipping, the remainder of the card was sent to the produc- 
tion office. 

Production superintendent Johnson controlled the inventory levels of 
stock items. When stock items were worked down, a cutting order was 
made for each item to be produced and assigned to a nail maker who 
produced this item and posted a production card for each tote box finished 
until Mr. Johnson gave him a new assignment. These production cards 
were also posted on a control board to provide Mr. Johnson with a check 
on actual quantities being produced. When Mr. Johnson believed there 
was enough on hand he gave the nail maker a new assignment and the 
items were placed in storage to await shipment. 



210 The Bayard Nail Company 

All production records were kept in pound figures and totaled by the 
production and accounting offices. For example, each tote box completed 
was weighed by the nail maker and its weight recorded on the produc- 
tion card; all issues from stock, chiefly wire rolls, were recorded in terms 
of number of reels of wire, extended at a standard weight; all shipments 
were weighed and recorded on shipping slips and bills of lading; and all 
scrap was recorded by weight. 

Management believed, however, that there were some inaccuracies in 
these records. For example, reels of wire issued to the floor were not al- 
ways completely recorded and the standard weights for reels of wire 
were not exact; and the tote pans used to carry nails were of two types 
and the recorded weights of these pans, when full, did not always reflect 
the weight differences between the two types of pans. 



ACCOUNTING 

The accounting department collected labor, material and overhead 
costs by departments monthly for the determination of inventory values 
and profit. Exhibit 4 indicates the procedure used to charge overhead 
through service departments to productive departments. The totals of 
actual overhead and labor charged to each department monthly were 
distributed to the pounds of production processed in each department, 
except that three overhead expenses (rent, general insurance, and de- 
preciation) were considered fixed costs and were excluded from the unit 
cost computations. The fixed costs were deducted, however, as a period 
charge from the monthly cost of goods sold figures. 

The major task of the accounting staff was to trace production quantities 
and costs through the productive departments. The manner in which this 
was done, both monthly and annually, is described below. The steps in 
this procedure may be followed by comparison with the worksheets for 
August 1958, which appear as Exhibits 5 and 6. 

Monthly Procedure. The company's books were closed monthly and 
annually by separate procedures. The monthly closings occurred outside 
the regular books of accounts and were designed to provide quick, reason- 
ably accurate statements. The major element in the monthly procedure 
consisted of determination of departmental labor and overhead costs and 
the value and quantities of inventory and production. 

In the nail-making department beginning wire inventory was assumed 
to remain constant at the amount existing when the company was pur- 
chased in 1956; and the same wire was assumed to remain in inventory at 
the weighted average invoice price of the wire at the time of the 1956 
purchase. Wire on or at machines was also assumed constant monthly at 
an estimated 12,000 pounds (50 per cent completed) but was valued at 



The Bayard Nail Company 211 

current material prices plus the labor and overhead cost per unit of 
production for the preceding period. (The determination of labor and 
overhead cost per unit of production is described below.) 

The value and pounds of beginning wire inventories were added to 
pounds and value of wire sent to the floor during the month. These 
figures were determined from stock room records of issues valued at 
weighted average invoice price. Total labor and overhead for the nail- 
making departments were then added to arrive at total pounds and cost 
of inputs. 

Ending work in process consisted of the constant pounds and dollar 
value of wire stock plus wire on and at machines which was a constant 
pound figure valued at current weighted average invoice price and a labor 
and overhead charge determined by multiplying one-half of the constant 
pound figure (50 per cent complete) by an average labor and overhead 
cost per unit. This unit cost was obtained by dividing total pounds input 
into total departmental labor and overhead costs. The value and quantity 
of ending work in process was subtracted from the input figures to de- 
termine the transfer to the roller department. 

In the roller department the ending inventory of work in process for 
the preceding period was added to transfer figures from the nail-making 
department. This sum was added to the actual labor and overhead for 
the roller department to get total pounds and cost of inputs. Inspection 
of nails occurred for the first time at the end of the rolling operation and 
all scrap was weighed and recorded, and then removed from the pounds 
input figure. Then, by subtracting the pounds finished and transferred 
from the roller room (recorded in production report) the ending work- 
in-process quantity was arrived at. This inventory was valued at the aver- 
age cost of material available to the roller room during the period, plus 
a charge per pound for labor and overhead in the roller department 
(assuming again 50 per cent completion). Then the pounds and cost of 
work in process were removed from total inputs to obtain cost of transfers. 

All nails from the roller department were transferred to finishing de- 
partments which were treated as one cost department. It was assumed 
that no inventory remained in these departments since the production 
cycle required only a few hours. A labor and overhead charge was de- 
veloped, however, and applied against all transfers to indicate the cost 
and pounds of total production for the period. These two figures were 
used to determine the average unit cost of production. 

Cost of goods sold was determined monthly in the following manner: 
the average unit of cost of production was used to cost sales for material, 
labor and variable overhead if production exceeded sales; the excess 
of production was added to finished inventory at its average cost; and 
a new average cost of finished inventory was determined. If sales ex- 
ceeded production, the finished inventory draw-down was added at its 



212 The Bayard Nail Company 

average cost to the cost of production for the month. Finally, fixed over- 
head costs and an estimated cost of shipping containers were deducted 
to obtain a total manufacturing cost of goods sold. 

Annual Profit Determination. Annually, an average total unit (per lb) 
manufacturing cost ( the costs in Exhibit 4 ) was calculated to value end- 
ing finished inventories which were determined by a physical count. Total 
manufacturing costs, less packing and shipping department expense, were 
divided by total pounds worked on to obtain this unit cost. Total pounds 
worked on was determined by adjusting the total transfers from the 
roller department for beginning and ending inventories of work in process 
at estimated stages of completion (Exhibit 6). 

The unit cost figure was applied against three classes of nail inventories: 
packed, loose, and in process (latter adjusted for per cent completed). 
Each class was then charged with an average wire cost plus freight-in 
and an estimated scrap factor. Then, packing expenses were allocated to 
total goods packed and charged against packed ending inventory and 
sales. All other inventories (e.g., wire, packing materials, and supplies) 
were counted by physical inventory and valued at actual or average 
actual cost. 

Goods sold were costed at their unit manufacturing cost, average wire 
cost and their share of packing costs and supplies. The cost and quantities 
of the year's production were added to the cost and quantities of begin- 
ning inventory to determine new average unit costs for ending finished 
inventory and cost of goods sold figures. 



CHANGES IN ACCOUNTING SYSTEM 

During the second year of operations, the new management of Bayard 
was thinking of making several changes in the company's accounting sys- 
tem. One of these proposals was based upon management's desire to trace 
inventory through the individual finishing departments. Another was 
based on the desire for some standard cost data on different lines of nails. 

The inventory control of finishing operations was not detailed yet, but 
management planned to follow similar procedures to what they were 
doing in the nail making and rolling departments. The standard cost data 
was to be based on historical performance in the following manner: Dif- 
ferent nail lines were identified and the average number of nails per 
pound for each line would be determined; the machines used for different 
nails would be determined and the output of these machines in lbs/hr 
would be estimated from recorded production data. Then, the machine 
hours per 100 lbs. would be calculated for the nail-making and rolling 
departments. A standard departmental cost rate per machine hour could 
then be determined by dividing total recent average labor and overhead 



The Bayard Nail Company 213 

for the department by the machine hours utilized during the same period. 
Then a standard cost per cwt. of each line could be determined by mul- 
tiplying standard hours per cwt. times departmental rates. This same tech- 
nique was to be applied to finishing operations, but inadequate historical 
data was temporarily preventing any action. However, data was being 
collected for future use. 

Management believed that these standard costs would be useful for 
the determination of unprofitable items in their product line, and as a 
basis for pricing new products. 



OPERATIONS-SECOND FISCAL YEAR 

During the first six months of operations for fiscal 1958 ending Feb- 
ruary 28, the Bayard Nail Company lost $6,000 bringing the total for 
the first 18 months of operation to slightly over $91,000 (Exhibit 7). Al- 
though creditors were concerned over the balance sheet figures and slow 
payments, the improved income statement had provided hope that they 
would be paid eventually. Mr. Steel had not been successful in obtaining 
substantial additional equity financing and was negotiating with the SBA 
for an additional $40,000. 

In response to a drop in sales volume during the early months of 1958, 
the management switched operations to a one-shift, three-day-week basis 
to bring inventories into line with reduced demand. Management also 
altered their sales relationships with American Shoe Distributors, offering 
a net 5 per cent commission instead of the former gross 15 per cent, and 
Bayard handled the receivables. In addition, Bayard assumed more selling 
and servicing activities by increasing its sales force to five men. This latter 
change in policy resulted from management's general dissatisfaction with 
the sales effort and ability of American. By assuming the receivables 
Bayard increased its borrowing based on receivables by about 100 per 
cent. Management also increased direct mail advertising and sales super- 
vision. During the last half of fiscal 1958 Bayard company's sales in- 
creased, reaching $73,000 in August, and profits were recorded in June, 
July, and August 1958. 

During the winter of 1958 two students of business, introduced to the 
firm through an accounting research project, were given permission to 
prepare the profit and loss statements for December, January, and Feb- 
ruary and for the six months ended February 28. Excerpts from their 
report on this project follow: 

Closing the Books 

Problems occurring in the preparation of the profit and loss statements 
and balance sheets were found to be roughly of four types. The first of 



214 The Bayard Nail Company 

these concerned closing the books. Specifically, we found that trial bal- 
ances tended to be late. This was of little consequence for the December 
and January statements because we did not get to work on these until the 
beginning of February and the end of February respectively. However, it 
showed itself to be a problem in the preparation of the February state- 
ments. By this time, we had caught up and were ready to start work on 
February as soon after the last day of the month as the trial balances were 
ready. However, they were not available until the middle of March, thus 
precluding the February statements being available to a creditor who was 
asking to see them by the middle of March. 

Tardiness of the trial balances is not to be taken as an indication that 
the bookkeeper is not doing her job. Rather it is further evidence of the 
heavy work load placed on the company's office staff. To correct the situa- 
tion would require an addition to the staff, which Bayard's financial condi- 
tion prohibits. Hence, we feel that the company will continue to have to 
live with this problem. 

A second problem in closing the books, and one that is much more 
serious than late trial balances, is that factory production records to date 
have not been accurate. On average reported monthly factory production 
of 280,000 pounds, input and output figures failed to reconcile during 
December, January, and February by from 12,000 pounds to 70,000 
pounds. It was necessary, in each statement we prepared, to guess the 
relative validity of various production figures, and on this basis to reject 
one of them in favor of a plugged figure, in order to strike a balance. As 
can be seen, this problem cuts across all the areas inherent in our four 
centers of attention, and will be gone into in greater detail later in this 
report. 

Valuing Inventory 

The second of the four types of problems confronting us was that of 
valuing inventory. This is an extremely critical area for the company in 
that inventories constitute about 60 per cent of their total assets. Any 
significant change in inventory value can spell the difference between 
being able to continue operations and having to go out of business. For 
example, in preparing the statements for the six months ending February 
28, 1958, we had available to us two possible costs per pound for finished 
goods inventory. The difference between them was $.02 per lb, yet one 
produced a $22,000 loss for the period, while the other reduced this to 
$6,000. Mr. Richards intends to take the February statements to the 
Small Business Authority to support his request for a $40,000 loan. If the 
statement showing the $22,000 loss had been taken, the SBA would be 
confronted with a firm that had lost 63 per cent of its equity in its first 
year of operation and had dropped 38 per cent of its remaining year-end 
equity during the first six months of its second year. It is extremely un- 
likely that the SBA would consider any further loans. Rather, it seems 
more likely that it would become somewhat nervous about the $56,600 
outstanding on its present loan to the company. On the other hand, if Mr. 
Richards were able to show them only a $6,000 loss, this would indicate 
that the company had been able to reduce its loss rate to 9.8 per cent of 
its remaining first year equity. Since this had been done in the face of an 
extreme recession in the shoe industry (Bayard's major customer), it is 
likely that the SBA would consider favorably the loan request. 

The two methods of valuing finished goods inventory available to us for 



The Bayard Nail Company 215 

the February statements were derived as follows, (a) The first was 
derived by combining departmental production and cost records to produce 
departmental costs per thruput pound. A physical inventory was then 
taken and segregated into portions dependent upon the departments 
through which these portions had flowed. The portions were then costed 
at the sum of the thruput costs per pound of the departments involved. 
For example, plain nails bore only the costs of the nailmaking and rolling 
departments plus material costs ($17.18) while threaded nails bore an 
added $2.11 for the threading department. By this method, inventory was 
valued at $205,000. (b) The second method was to extend the total 
pounds of finished goods at the average cost of production for the six- 
month period (9/1/57-2/28/58) as determined by a calculation similar 
to that used to determine CGS in the monthly procedure (see Exhibit 10). 
Using this method, inventory was valued at $221,000. 

The first of these methods, that of segregating finished goods by the 
types of operations performed on them, would seem to be an excellent 
way of overcoming mix problems that are inherent in the average cost 
method. Under the averaging procedures of both the monthly and year- 
end methods, distortions would occur in both CGS and Finished Goods if 
there were any material differences between the mix of product produced, 
the mix of product sold, and the mix of product in finished goods inven- 
tory. We felt, however, that this could be overcome if there were segrega- 
tion of inventory. The segregation using this method is not complete 
enough, however, to take care of the problem. Rather, it continues to 
distort the statements. One of the reasons for this is that this method 
assumes that all the pounds of product that go through a given depart- 
ment require the same amount of departmental effort. This, unfortunately, 
is not the case. For example, it does not take as long to thread a pound 
of building nails as it does to thread a pound of small shoe nails, simply 
because a pound of wire can make more small nails than large ones and 
the threading machines run at a fairly constant speed per nail. . . . 

Because of the noted inaccuracies of the segregation method of inven- 
tory valuation, Mr. Richards requested that we recalculate the statements 
for the six-month period ending February 28, 1958 using, instead, the 
six-month average cost of production. He had hoped that the segregation 
method would yield a more accurate valuation, but from the results, it 
was apparent to him that it was not as valid as the averaging method. In 
addition, he felt that for purposes of creditor examination, the averaging 
method would yield statements that were comparable with those of 
August 31, 1957 when a very similar averaging method had also been 
used. 

Production Records 

The third of the four types of problems confronting us in the prepara- 
tion of the profit and loss statements and balance sheets was that of being 
able to place very little faith in the company's production records. This 
has been alluded to as contributing in large part to our difficulties in 
closing the books and in valuing inventory. It became particularly trouble- 
some in the recalculation of the six-month profit and loss. In order to 
determine the six-month average cost of production, it was necessary to 
know the amount of wire issued to the floor, the beginning and ending 
work-in-process inventories, and the transfers to finished goods. Column I 



216 The Bayard Nail Company 

of Exhibit 9 shows an attempted production and inventory reconciliation 
statement based on figures available from factory production records and 
from beginning and ending physical inventories. Column II show the 
figures that were finally decided upon for use in the statements. 

As can be seen from Exhibit 9, beginning wire inventory plus inputs 
less outputs would not balance with either the ending book or physical 
inventories. Beginning finished nail inventory, plus production (cut and 
rolled), plus returns, less shipments and scrap failed to agree with the 
ending physical inventory of finished nails. The material reconciliation 
calculation indicated a work-in-process inventory draw-down of 27,300 
lbs; yet a comparison of beginning and ending physical inventories in- 
dicated a draw-down of 73,800 lbs. 

To produce an average production cost calculation from this conflicting 
data, it was necessary to examine the individual items and to make judg- 
ments about their probable accuracy. Starting with the raw material 
portion, it was decided that the beginning and ending physical inventories 
were likely to be correct since Mr. Richards had personally supervised the 
counts. Since it was impossible to get a double check on the factory 
records of issues to the floor, factory receipt records were verified by an 
adding machine tape of the pounds shown on suppliers' invoices for the 
period. It was then possible to plug the issues figure and to be reasonably 
confident of its validity. 

The next step was to use the derived issues figure in the material recon- 
ciliation calculation to bring into balance the indicated and actual work- 
in-process draw-downs and thus plug the production (cut and rolled) 
figure. From here, it was possible to attempt to reconcile the finished nail 
production and inventory. 

Nails returned, nails shipped, and nails scrapped were felt to be correct 
since double checks had been provided by outside sources. Using these 
figures with the derived production figures, an indicated ending inventory 
of finished nails was then produced. It will be noted that this ending 
inventory disagrees with the ending physical inventory by 10,300 lbs. Mr. 
Richards attributed this discrepancy to a known error in the taking of the 
9/1/57 physical inventory when a quantity of household mix nails had 
been overlooked. 



Required 

1. What inventory valuation should be used? Draft a memorandum for Mr. 
Richards setting forth the reasons for your recommendations. 



EXHIBIT 1 



Comparative Balance Sheets,* 1957 



ASSETS May 31, 1957 August 31, 1957 

Current assets: 

Cash $ 6,790.11 $ 16,857.32 

Accounts receivable— customers 58,722.90 70,479.73 

-other 563.56 

Inventory 185,237.28 181,284.69 

Prepaid insurance and expense 6,924.36 1,445.61 

Total current assets $257,674.65 $270,630.91 

Fixed assets: 

Machinery and equipment! 62,000.00 67,417.78 

Auto and truck 1,747.48 

Less: Depreciation (6,505.51 ) 

Net fixed assets $ 62,000.00 $ 62,659.75 

Unamortized organization: 

Expenses 1,409.46 

Total assets $319,674.65 $334,700.12 

LIABILITIES AND NET WORTH 

Current liabilities: 

Notes payable $ 34,483.43 $ 40,370.55 

Accounts payable 84,428.18 103,261.33 

Accrued and withheld taxes 9,796.50 39,257.17 

Accrued wages and expenses 4,218.39 10,173.51 

Total current liabilities $132,926.50 $193,062.56 

Long-term liabilities: 

Notes payable 51,800.00 66,382.67 

Notes payable and accrued 

interest-officers 35,000.00 35,505.83 

Salaries and installment obligations .... 4,813.49 

Total long-term liabilities $ 86,800.00 $106,701.99 

Net Worth: 
Capital stock 
Common— no par authorized— 20,000 

shares issued and outstanding (10 shs.) 110,000.00 120,000.00 

Operating surplus (deficit) (10,051.85 ) (85,064.43 ) 

Net worth $ 99,948.15 $ 34,935.57 

Total liabilities and net worth $319,674.65 $334,700.12 

♦The May 31, 1957, statement was not audited and Mr. Richards believed it 
was inaccurate due to accounting technique: overvaluation of inventories and un- 
derstatement of accruals. 

jValued at purchase price. Appraised value determined by a Factory Mutual 
Insurance Company at approximately $335,000.00 



217 



EXHIBIT 2 



Comparative Statements of Profit and Loss 



9 Months Ending 
May 31,1957 



Sales 

Less: Returns and allowances 
Net sales $487,375.37 

Cost of sales 

Inventories— beginning . . 

Purchases 

Labor and manufacturing 
overhead 



Less: Inventories— ending 

Total cost of sales . . . 425,718.97 
Gross margin $ 61,656.40 

Selling and administrative: 

Advertising 

Commissions 

Freight out 

Insurance 

Legal and professional 
Research and development 
Salaries— executive .... 

— office 

— sales 

Taxes— miscellaneous . . 

Travel 

Miscellaneous expenses _ 

Total $ 

Net loss from operations . . ($ 



6,516.08 



Other charges: 
Sales discounts . 
Interest expense 
Bad accounts . . 



6,516.08) 

10,917.04 
2,568.30 



% of 
Net Sales 



87.4 
12.6% 



14.0 % 
( 1.4%) 

2.2 
.5 



Fiscal Year 
August 31, 1957 

Net Sales 



$ 

$675,026.51 
15,659.15 



317,892.20 
$798,936.80 

181,284.69 
$617,652.11 
$ 41,715.25 



3,022.67 
1,356.22 

23,968.95 
2,043.20 

20,587.49 
5,277.20 

12,480.90 

18,947.89 
8,871.88 
4,268.85 
7,670.03 

14,903.63 
$123,398.91 
$ 81,683.66 



6,089.05 

5,939.08 

112.65 



Other income: 

Scrap sales 

Other 

Net loss* ($ 



5,612.10 
4,337.47 



1.2 

.9 



8,022.54 
737.47 



102.4% 
2.4 



100.0% $659,367.36 100.0 % 

135,252.52 
345,792.08 



93.7 % 
6.3% 



.5 

.2 
3.6 

.3 
3.1 

.8 
1.9 
2.9 
1.3 

.6 
1.2 
2.3 



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12.4% 



($ 20,001.42) ( 4.1%) ($ 93,824.44) ( 14.2%) 



1.2 
.1 



10,051.85) ( 2.0%) ($ 85,064.43) ( 12.9%) 



*Mr. Richards believes that the net loss figures are misleading due to the fact 
that accounting procedure used to derive the unaudited May 31, 1957, profit and 
loss statement greatly understated the loss for the first nine months of operations, 
thus causing high overstatement of losses in the fourth quarter. 



218 



EXHIBIT 3 



Analysis of Net Loss from Operations for 
Year Ended August 31, 1957 



Excess labor and direct overhead costs for 10 months of the year 

(estimated at $300 per week) $12,000 

Training of nail makers (8 men for 6 months) 15,000 

Moving machinery and rearrangement of production departments 5,000 

General cleaning of plant areas 1,500 

Reinspection of returned merchandise 1,500 

Rehabilitation of production machinery (other than nail machines) 2,500 

Duplication of plant supervision labor— 6 months 3,500 

Powasert sales promotion salary and expenses 4,000 
Weekly employee relation bulletin and nonrecurring production 

system costs 300 

Sales commissions to unsuccessful agents 250 

Cost of stationery and expenses for revision of bookkeeping system 1,000 

Painting offices 500 

Legal fee in connection with union election procedures 750 

Nonrecurring research expenditures 5,000 

Unusual sales department travel expenses in connection with change 

of ownership 750 

Direct expense of enlarging agents' distribution 1,500 

Unusual advertising expenditures for price lists and direct- mail lists 5,000 
Legal and accounting fees relating only to initial operations and 

systems revisions 3,000 

Estimated cost of samples of stock and experimental nails for sales 

groups (12,000 lbs. at $25 cwt.) 3,000 

Estimated loss on rubber heel nails for six months from date of steel 
price increases (February and July 1957) at average of 75 cents per 
cwt. (300,000 lbs.) (This item does not include total loss estimate 
of at least $20,000 on development and manufacture of the rubber 

heel nails during the fiscal period.) 2,250 

Estimated loss on production of experimental tacks (50,000 lbs. at 

$10 cwt.) 5,000 

Total $73,300 

In addition to these costs there was approximately $3,500 of expenses which 
will benefit future fiscal periods. This item consists of new thread rolling dies, 
sifter screens, and other production items which are in the nature of deferred 
expenses, but have been charged to the operations of the first fiscal year. 



219 



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220 



EXHIBIT 5 



Monthly Inventory Valuation and CGS Determination 



April 1958 



Pounds 
Nail Making Department : 
In process— beginning: 

Wire 25,000 

Wire on & at machines 12,000 

37,000 
Current charges: 

Wire 601,309 

Labor & overhead 

Total charges 638,309 

Work in process end: 

Wire on floor 25,000 

Wire on & at machines— mat 12,000 

labor & OH 

Total WIP 37,000 

Goods finished 601,309 

Roller Department : 

Cut nails in process— beginning 75,932 

Transferred from nail department .... 601,309 

Total materials 677,241 

Labor and overhead 

Total charges 677,241 

Less normal scrap 48,962 

628,279 
Work in process— end 

Wire on & at machines— mat 128,242 

labor & OH 

Total WIP 128,242 

Goods finished 500,037 

AUOther Departments 

In process 

Transferred from roller department . . . 500,037 

Labor and overhead 

Nails completed 500,037 

Cost of Goods Sold : 

Sales 531,022 

Production 500,037 

Inventory draw-down 30,985 

Variable cost of sales 

Fixed costs 

Container costs 

Cost of goods sold 



Unit Cost Total Cost 





$ 2,084.39 

1,240.62 

$ 3,325.01 


$0.09 


$ 54,117.81 

18,864.02 

$ 76,306.84 


0.03137* 
0.1213 


$ 2,084.39 

1,080.00 

188.22* 

$ 3,352.61 

$ 72,954.23 


0.1216 
0.13225 


$ 9,377.98 

72,954.23 

$ 82,332.21 

7,233.68 

$ 89,565.89 




$ 89,565.89 


0.1216 
0.12581 


$ 15,594.89 
806.641 
16,401.53 
73,164.36 


0.2104 


$ 73,164.36 

32,025.24 

$105,189.60 


0.17416 
0.2178 


$105,189.60 
5,396.37 

$110,585.97 
3,557.78 
1,500.00 

$115,643.75 



*Since the equivalent of 601,309 pounds were started and completed a labor & 
overhead rate per pound was computed by $18,864.02 * 601,309 (beginning and 
ending "wire on & at machines" always assumed 50% complete). 

fSince the equivalent of 575,154 pounds were started and completed (including 
scrap), labor and overhead rate = $7,233.68 -r 575,154 (beginning and ending WIP 
assumed 50% complete). 



221 



EXHIBIT 6 



Year End Inventory Valuation- 
Finished Nails and Work in Process 



Pounds Manufactured : 

In process— beginning (10% complete) . 10,223 9,201 

Nails finished 3,309,963 

In process-beginning 10,223 3,299,740 

In process-end (90% complete) 74,955 67,460 

Finished equivalent 3,376,401 

Manufacturing Costs : 

Labor and overhead $318,506.00 

Less packing costs— bulk $27,681.45 

-small 26^612.59 



Net manufacturing cost $264,211.96 

Average manufacturing cost/lb. ($264,211.96 -r 3,376,401) $0.07825 

Ending Inventory Packed Loose In Process Total 

Pounds 313,870 242,295 74,955 631,120 

@ $0.07825/lb $24,560.33 $18,959.58 $ 5,278.71 $ 48,798.62 

Wire cost @ $0.1010/lb. 31,700.87 24,471.80 7,570.45 63,743.12 

Total material and 

labor $56,261.20 $43,431.38 $12,849.16 $112,541.74 

Packaging labor and 

overhead (1.577/cwt.) 4,949.73* 4,949.73 

Packaging material . . 1,961.68 * 1,961.68 

Total inventory values $63,172.61 $43,431.38 $12,849.16 $119,453.15 



* Packing Analysis 

Nails sold 3,230,000 

Ending inventory -packed 313,870 3,543,870 

Beginning inventory— packed 100,000 

Total pounds packed 3,443,870 

Packing labor and overhead $54,294.04 

Packing labor and overhead rate/cwt. $1,577 

Packing materials: 

1-lb. packages @ $1.1000/cwt. 41,721 lbs. $ 458.93 

5-lb. packages @ 1.0000/ cwt. 71,559 715.59 

50-lb. packages @ 0.3924/ cwt. 200,590 787.16 

Total packaging materials 313,870 lbs. $1,961.68 



222 



EXHIBIT 7 



Balance Sheet 

February 28, 1958 

CURRENT ASSETS: 

Cash in banks and on hand $ 6,124.26 

Accounts receivable 59,516.02 

Travel advances 288.39 

Inventories 221,785.11 

Prepaid expenses & insurance 2,075.44 

Total current assets $289,789.22 

FIXED ASSETS: 

Machinery & equipment $70,393.16 

Auto & truck 1,747.48 

Office equipment 1,859.10 

$75,999.74 

Less: Accumulated depreciation 10,165.51 63,834.23 

Unamortized organization expense 1,259.46 

TOTAL ASSETS $354,882.91 

LIABILITIES: 

Notes payable— Boston bank $36,000.00 

— Framingham bank 10,140.00 

-SBA 56,607.02 

-Other 14,300.69 

$117,047.71 

Accounts payable 77,854.49 

Accrued salaries & wages 6,855.71 

Miscellaneous accruals— employees 205.25 

Accrued expenses 12,729.85 

Notes payable— officers 35,505.83 

$250,198.84 

NET WORTH: 

Capital stock 195,926.35 

Operating deficit (91,242.28 ) 

TOTAL LIABILITIES AND NET WORTH $354,882.91 



223 



EXHIBIT 8 Profit and Loss Statement 

9/1/57 - 2/28/58 

Pounds Unit 

Gross sales 1,650,700 $374,125.08 

Less: Sales allowances & 

adjustments 39,800 10,075.76 

Net sales 1,610,900 

Cost of sales 

Freight out 

Gross margin (11.20% of net sales) 

Selling & administrative: 

Selling 

Administrative .......... 



Loss from operations 

Other expenses: 

Interest expense 

Sales discounts 

Massachusetts corp. excise tax 



Scrap sales 

Miscellaneous income 



Net loss for period .... 
Deficit, August 31, 1957 • 
Deficit, February 28, 1958 



$0.22599 
0.19100 
0.00968 


$307,676.95 
15,585.91 


$364,049.32 

323,262.86 
$ 40,786.46 




$ 11,192.88 
29,952.68 


41,145.56 
($ 359.10) 




$ 3,572.37 

3,791.15 

539.22 




$2,001.09 
82.90 


$ 7,902.74 
2,083.99 


5,818.75 

($ 6,177.85) 
($ 85,064.43) 
($ 91,242.28) 



224 



EXHIBIT 9 Production and Inventory Reconciliation 

Pounds 
9/1/57 - 2/28/58 

Based on Figures Used 
Production Records in Statements 

Wire 

Beginning balance 9/1/57 317,200 317,200 

Received 1,673,300 1,696,500 

Total 1,990,500 2,013,700 

Less issues 1,850,300 1,833,500 

Balance 140,200 180,200 

Physical inventory- 2/ 28/58 180,200 180,200 

Book inventory- 2/ 28/ 58 175,900 175,900 

Physical over-(under) balance 40,000 

Nails 

Beginning balance-9/ 1/57 556,200 556,200 

Cut and rolled 1,689,800 1,724,000 

Total . . . 2,246,000 2,280,200 

Nails returned 39,800 39,800 

Total 2,285,800 2,320,000 

Less nails shipped 1,615,100 1,615,100 

Net 670,700 704,900 

Less nails scrapped 2,600 2,600 

Balance 668,100 702,300 

Physical inventory- 2/ 28/ 58 712,600 712,600 

Physical over-(under) balance " 44,500 ~ 10,300 

Material Reconciliation 

Wire issued 1,850,300 1,833,500 

Less scrap reported 187,800 187,800 

Net material into nails 1,662,500 1,645,700 

Nails cut and rolled 1,689,800 1,724,000 

Indicated WIP draw- down 27,300 78,300 

Physical inventory in process 9/1/57 

Wire on floor— nail making 24,900 24,900 

Wire on machines 6,000 6,000 

Nails cut— not rolled 75^00 75,000 



Total (A) 105,900 105,900 

Physical inventory in process 2/28/58 

Wire on floor & at machines 20,300 20,300 

Nails cut— not rolled 7,300 7,300 

Total 27,600 27,600 

Actual WIP draw-down [(A) -(B)] ... (B) 78,300 78,300 



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226 



ASSETS: VALUATION AND AMORTIZATION 



CASE 29 



Waters 

& Son, Inc.* 



A' 



t a meeting of the board of directors of Waters 
& Son, Inc., in February 1955, one of the mem- 
bers raised an inquiry concerning the company's depreciation policy. 
Several of the directors felt a review of the depreciation policy would be 
most timely, as a new two and one-half million dollar roofing plant * was 
scheduled for completion during the month. It was recommended that 
Paul Lewis, secretary-treasurer, have a study prepared considering the 
effects upon the financial operations of the company of changing from 
the straight-line method to any of the other accepted depreciation tech- 
niques recognized for Federal income tax purposes. 2 

Waters & Son, Inc., was a manufacturer of asphalt shingles, insulated 
siding, linoleum, felt-base floor covering, shipping cases, paper boxes, and 

1 The building costs were estimated at $700,000 and machinery and equipment 
costs at $1,800,000. 

2 The Revenue Act of 1954 recognized under certain conditions the use of more 
liberal methods of depreciation than had previously been accepted. The methods in 
general use prior to 1954 were the straight-line method and unit of production 
method. The limited declining balance method and other consistent methods spe- 
cifically approved by the commissioner could also be used. Effective January 1, 1954, 
the sum-of -years-digits method and the double declining balance method were recog- 
nized for new properties acquired after 1953. 

* Copyrighted 1955 by the Faculty of the School of Business, University of Kansas. 

227 



228 Waters 6- Son, Inc. 

many other related items. The building materials industry was highly 
competitive and marketing prices were beyond the control of any one 
producer in the industry. These items were normally produced for stock 
and on a relatively stable production schedule through the year. The 
company had for many years controlled approximately 10 per cent of the 
total market for roofing materials and linoleum. Due to the high costs 
of transportation, the paper box industry was generally considered a 
regional industry servicing a relatively small geographical area. These 
products were made on special orders and on contract. Even though the 
paper box division produced an important part of the firm's total sales, 
its output was a negligible part of the paper box industry. 

The company was organized as a partnership about 1800 in New Eng- 
land and had been controlled by the Waters family through the years. 
In 1918 the company was incorporated; since that time the number of 
stockholders had increased steadily. The stock was not listed on an ex- 
change; in fact the majority of the common stock was held by the family, 
employees, and others directly associated with the business. The com- 
pany operated seven plants scattered throughout New England, the 
Midwest, and the South. The major factor in the location of these plants 
was their proximity to the areas of distribution of their products. A 
subsidiary company which produced a related product was wholly owned 
by Waters & Sons, Inc. 

At a meeting of his staff, two days following the board meeting, Paul 
Lewis stated: "Several of the directors seem to have a strong feeling that 
we should change our depreciation policy to one which gives us the 
most favorable income tax position. They have asked us to prepare a 
study of the effects of such a change in policy ." 

"We have for so many years consistently used the straight-line method 
of depreciation applied to groups of assets that any departure now would 
destroy all comparisons and variances which we have been computing 
and analyzing each month," retorted Tom Allen, the office manager. 

The cost accountant, Henry Richard, added: "I agree with Tom. Top 
management has watched these variations and changes so closely that 
we even include in our cost comparisons depreciation on fully depreciated 
equipment that is still in use. This necessitates an extra adjustment in the 
general accounting department to pull out this depreciation on the fully 
depreciated assets before the company statement can be prepared." 

"A change in depreciation policy could have an effect upon a great 
many items around here as well as our net income and the income tax 
liability— what about working capital?" commented George Harrison, the 
assistant treasurer. 

After considerable discussion, Paul Lewis interrupted: "This is all fine, 
but what we need are facts and figures to point out the effects and to 
support any proposals we wish to make. I suggest we decide what data 



Waters 6- Son, Inc. 229 

we need and when it is prepared I will distribute it to each of you for 
your consideration. We can plan to meet again in about ten days to 
discuss this further and attempt to draw up a tentative report." 

It was suggested that balance sheets and income statements for five 
years would be necessary. "That would be for the years 1950 through 
1954. I think we should include 1949 also," suggested George Harrison. 
"As you remember in 1950 we were shut down for eleven weeks due to 
a strike." This was agreed upon as a good suggestion. 

"I could not get a detailed breakdown on each and every classification 
of building and machinery, except by going back through all the detail 
plant ledger cards. 3 I am not certain this would provide any useful or 
necessary information if it were done," commented Tom Allen. "From 
studies made by our auditors, we know that buildings amount to ap- 
proximately 40 per cent of the totals in the fixed asset accounts; ma- 
chinery, equipment, and other incidental items make up the balance." 

George Harrison observed: "Repair costs are relatively stable due to 
our policy of constant upkeep and maintenance, most of which is done 
by our own employees. Also there appears to be no marked increase in 
repair costs due to age or amount of use of most of the equipment." 

"This is true, partially at least, due to the fact that most of our ma- 
chines are large and slow moving and thus are not subject to the extreme 
wear that is true of high speed, precision equipment," added Larry 
Long, the company auditor. "Also, obsolescence is not a major factor 
with us. Most of our new machines are similar to those we have been 
using for many years. By the way, when mentioning various items to be 
considered, we do not want to overlook the effect upon the employee 
retirement plan, which is partially based on profits." 

After determining the data to be assembled by the respective men 
and their assistants, the discussion in the meeting shifted to other routine 
matters. 

During the next several days, the suggested data were prepared and 
given to Paul Lewis for reproduction and distribution to the various men. 
Included were the following: 

( 1 ) Comparative consolidated balance sheets as of December 31, 1949 
through 1954 (Exhibit 1). These were taken from the annual stock- 
holders' reports. 

(2) Comparative consolidated statements of earnings for years 1949 



3 All expenditures including labor and applied overhead for additions, replace- 
ments, and repairs were accumulated on work orders which were reviewed as to 
proper charge. All orders which in any way increased or added to the value of the 
buildings or equipment were capitalized in the property accounts. These were classi- 
6ed as to division, plant, building location, and estimated life. A separate plant ledger 
card was maintained for each subclassification which numbered approximately 8,000. 
Annual depreciation rates averaged 3 per cent on buildings and 7^ per cent on 
machinery and equipment. 



230 Waters 6- Son, Inc. 

through 1954 (Exhibit 2). These were also taken from annual stock- 
holders' reports. 

(3) Schedule of fixed assets and reserves for years 1949 through 1954 
(Exhibit 3). 

Paul Lewis outlined his opinions as to the future of Waters & Son, Inc., 
in a written statement and distributed it to his staff together with the 
other data. 

"Indications are that business will continue at a high level throughout 
the coming years, and we expect that this activity will be reflected in an 
increasing demand for our full line of products. 

"The successful growth of our business is due to the fact that for many 
years a substantial portion of our earnings has been plowed back' into 
the business in order to improve our facilities and carry on our research 
and engineering program which is devoted to product improvement, the 
development of new products, and cost reduction through more efficient 
operation. 

"Our capacity has been increased during the past few years and with 
our policy of adding facilities and plants in those areas which can no 
longer be economically served from our other plants, our total produc- 
tion and sales volumes should continue to rise. Continuation of this policy 
of additions as rapidly as our financial structure will permit should allow 
us to retain and perhaps increase our share of the market beyond the 
10 per cent we now hold." 



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234 



EXHIBIT 3 



Schedule of Fixed Assets and Reserves for Years 

from 1949 to 1954 

(Dollars expressed in thousands) 



WATERS & SON, INC. 
and Subsidiary Company 







Fixed Assets 








Beginning 
Balance 


Additions 
Expenditures 




Deductions 




Year 


Retirements 


Write Off of 
Fully Deprec. 


Ending 
Balance 


1954 


$24,962 


$3,595 


$116 


$541 


$27,900 


1953 


24,256 


1,078 


155 


217 


24,962 


1952 


22,453 


2,304 


218 


283 


24,256 


1951 


21,137 


1,817 


218 


283 


22,453 


1950 


20,313 


1,397 


205 


368 


21,137 


1949 


16,432 


4,022 


574 


(433) 


20,313 



Reserve for Depreciation 





Beginning 
Balance 


Additions 
Provision 




Deductions 




Year 


Retirements 


Write Off of 
Fully Deprec. 


Ending 
Balance 


1954 


$10,264 


$1,312 


$106 


$541 


$10,929 


1953 


9,252 


1,300 


71 


217 


10,264 


1952 


8,562 


1,164 


191 


283 


9,252 


1951 


7,926 


1,111 


192 


283 


8,562 


1950 


7,439 


1,047 


192 


368 


7,926 


1949 


6,692 


794 


480 


(433) 


7,439 



235 



CASE 30 



Shipstead 

Electronics Corporation 



The Shipstead Electronics Corporation was a large 
producer of radios, phonographs, and television 
sets. The company also produced related electronic equipment in spe- 
cialized fields for the government and private industry. Shipstead had 
plants throughout the world, and sales branches throughout the country. 
Although much of the production at Shipstead's plants was standardized, 
there were great technological advances which occurred too frequently 
to allow Shipstead to manufacture a product of standard parts for more 
than five years. Of course, many of the components of the radio and 
television sets were standard equipment on all models, and this type of 
production somewhat simplified the replacement problem. 

Fixed assets at Shipstead were grouped by classes of assets. Deprecia- 
tion rates were computed at specific rates by classes of asset on the gross 
value of all such assets in use by the company. For example, the com- 
pany depreciated plants of frame and light steel construction at a three 
per cent rate on the basis of an estimated life of 33% years. If the asset 
remained in use beyond the estimated life, however, the company con- 
tinued to depreciate the asset as long as there was any remaining un- 
depreciated balance on this class of asset. If the frame and light steel 
plant had been built in 1910 at a cost of $200,000, it would be fully 
depreciated by 1944. The company, however, would continue its yearly 
charge of $6,000 per year to operations as long as there was an un- 
depreciated balance on all plant buildings of frame and light steel, despite 

236 



Shipstead Electronics Corporation 237 

the fact that for tax purposes depreciation stopped after $200,000 had 
been recovered. This policy served to build up a so-called secret reserve 
which offset possible obsolescence of undepreciated assets. 

The effects of such a depreciation policy did not become pronounced 
so long as the company expanded. Shipstead had shown steady growth 
since its inception in 1902. Asset balances had continued to grow each 
year despite depreciation charges. However, as the plants and equipment 
grew older and remained in use, and the rate of company expansion 
dropped off or ceased, the imbalance between assets and reserves for 
depreciation became accentuated. At August 31, 1950, the amount of 
such fully depreciated property still on the books and still being de- 
preciated amounted to approximately $16,000,000 out of a gross value 
of depreciable assets of $100,000,000. The depreciation reserve was 
$42,000,000, and total assets at Shipstead were $175,000,000. Sales for the 
1949-1950 fiscal year amounted to $700,000,000, and profits after taxes 
were $20,000,000. Supplementary data on the financial position of the 
company and on its fixed assets are presented in Exhibits 1, 2, and 3. 

The setting of the depreciation rate at Shipstead was done by the chief 
accounting executive, the controller of the corporation. This rate was 
supposed to represent fairly the physical life of the plant, machinery, or 
equipment involved. Actually, however, the machinery either lasted a 
longer or shorter time than expected, because of technological factors. 
The physical life of plants could be extended almost indefinitely through 
preventive maintenance. In setting the life and rate of depreciation of an 
asset, the controller considered many factors: 

1. The tax rates allowable. \ 

2. Estimates of life made by manufacturers or contractors, engineers, 
or outside experts. 

3. Miscellaneous factors, such as the use to which the plant or machine 
would be put, the price or cost of the article, fragility, or other 
manufacturers' experiences. 

Depreciation rates were changed if the controller believed that an 
error had been made in the original estimate, but only if the estimate 
affected the whole class of assets and not merely one asset. 

Naturally the depreciation method followed by Shipstead, since it was 
not allowed for tax purposes, compelled the company to maintain two 
sets of records for fixed assets: one for taxes, and one for company use 
and annual report presentation. 

Recently the company estimated that it was creating a hidden reserve 
of about $600,000 per year. The problem of what depreciation policy to 
follow in the future assumed major proportions at Shipstead. The com- 
pany did not expect its business to expand substantially ( nor even at the 
same rate as previously) in the next ten years. It believed that it would 



238 Shipstead Electronics Corporation 

remain at approximately the same size, and that, over a period of years, 
the hidden depreciation reserve would thereby become extremely large 
in relation to other assets and liability accounts. 

The company gave three reasons for maintaining its present policy. 
First, Shipstead believed that it should recover, through an adequate 
selling price, the cost of its operations. The corporation felt that it should 
protect the investment of the stockholders, both dollarwise and in rela- 
tion to purchasing-power. It therefore reasoned that the product should 
bear the actual costs of operations, and not reflect paper profits which 
accrue because of low depreciation rates due to undervalued assets. Even 
though selling price was largely determined by competition, the company 
believed that price was still influenced by what the manufacturer be- 
lieved his price must be to cover his total costs and make a profit. 
Shipstead was afraid that if it did not depreciate on the gross asset 
balance of a group of assets, it would not recover the amount it should, 
and could, recover. 

The second reason given by the company for keeping the present de- 
preciation policy was that, although this rate created a reserve when 
assets outlived their depreciable life, Shipstead lost from the reserve when 
assets were retired before they were fully depreciated. The reason for 
this was that Shipstead never charged income with the undepreciated 
balance (gross value less salvage less depreciated amount gives unde- 
preciated balance). Instead, the total gross value less salvage was de- 
ducted from the depreciation reserve. Since the depreciation rate was 
based upon average estimated life, the apparent hidden gains and losses 
should have negated each other. Shipstead further argued that even 
though a reserve was being built up at the rate of $600,000 annually, it 
was impossible to determine obsolescence accurately in an industry as 
competitive and technologically advanced as radio, and that any year 
might bring an unexpected change which would cause Shipstead to 
scrap old machinery and buy new equipment. 

Finally the third reason why Shipstead was hesitant about shifting 
depreciation programs was the tremendous effect such a change would 
have initially on the balance sheet. The reserve would then become a 
"profit" in the eyes of the public, labor, and the stockholder, and pressures 
would be exerted upon Shipstead management by each group. Manage- 
ment at Shipstead was afraid that these pressures might seriously hamper 
the efficient operation of the company. 

Required 

1. The controller of Shipstead has asked you to say what you think should be 
done with regard to depreciation of fixed assets. Your review should present 
specific proposals both for record keeping purposes and for treatment in the 
annual report. 



EXHIBIT 1 



Summarized Balance Sheet— August 31, 1950 



ASSETS 

Current 

Cash $ 18,460,000 

U.S. Securities 4,370,000 

Accounts Receivable 34,540,000 

Inventories 53,722,000 

Prepaid Expenses 2,707,000 

Total Current $113,799,000 

Land, Buildings and Equipment $103,844,000 

Less accumulated depreciation 41,972,000 

$ 61,872,000 

Total $175,671,000 

LIABILITIES 

Current 

Accounts Payable $ 24,067,000 

Accrued Taxes 11,442,000 

Other 3,074,000 

Total Current $ 38,583,000 

Debentures-20 yr. Sinking Fund $ 16,400,000 

Capital Stock and Surplus 

Preferred Stock 31,000,000 

Common Stock 61,444,000 

Earned Surplus 28,244,000 

Total $175,671,000 



239 



EXHIBIT 2 



Supplementary Data 

Fixed Assets and Reserves for Depreciation 

August 31, 1950 





Assets 


Reserve for 
Depreciation 


Land 


$ 4,164,000 

22,404,000 

17,662,000 

3,174,000 

56,440,000 

$103,844,000 




Buildings 




Stone 


$19,807,000 

8,607,000 

824,000 


Brick 


Other 


Machinery and Equipment 


12,734,000 




$41,972,000 



Note: Depreciation charged operations for year ended August 31, 1950, totaled 
$3,864,000. 



Fully Depreciated Property, Based on Year of Acquisition 





Assets 


Depreciation 


Buildings 

Stone 


$ 13,200,000 
600,000 

2,564,000 
$ 16,364,000 


$16,047,000 
702,000 


Brick ' 


Machinery 

Lathes, Punch Presses 

Knobbing and Curling Machines 


3,176,000 
$19,925,000 



EXHIBIT 3 



Supplementary Data 



A sample survey of estimated remaining lives of fully depreciated assets now 
in use was made by the engineering office and, on sample, assets showed the fol- 
lowing range: 

Estimated Remaining Life 
Stone Building-(No. 44) From 1 to 10 years 

Based upon technological improvements, physical condition, and com- 
pany policy pertaining to centralization of manufacturing facilities. It was 
estimated that the only resale value of building No. 44 was a nominal sal- 
vage value. 

Machinery— (Plant No. 24) 

Turret Lathes From 1 to 3 years 

Based upon present technological improvement, the present machines 
are obsolete. Within the next several years, savings from new equipment 
should justify the purchase of new equipment. 



240 



CASE 31 



The Pan American 
Company 



The Pan American Company, one of the country's 
largest suppliers of printing inks and related 
chemicals, had just completed acquisition of a subsidiary late in 1956. 
With home offices in Chicago, the company had eight plants scattered 
throughout the country and sales offices in all the principal cities. The 
following data were taken from its 1955 annual report: 

Sales $100,106,000 

Net profit after taxes 4,707,000 

Total assets 58,075,000 

Capital stock 7,440,000 

Capital surplus 10,365,000 

Earnings retained in business . . 16,740,000 

Goodwill 1 

Immediately after the legal matters pertaining to the new acquisition 
had been settled, the president had a meeting with his controller and 
treasurer to discuss the effect of the acquisition on the balance sheet of 
the company. 

The following facts about the new acquisition were all agreed upon: 

Purchase price in stock of 

Pan American Company $740,300 

Tangible assets acquired = $490,300 

Excess of purchase price over book 

value of assets acquired 250,000 

$740,300 

241 



242 The Pan American Company 

The amount of $250,000 representing excess of the purchase price over 
book value of assets acquired did not include any trademarks or patents 
of any significant value. 

The president said that, as the company had not made a practice of 
showing goodwill at other than the nominal value of one dollar, he would 
prefer to write off the goodwill against capital surplus. The treasurer 
said this would be improper; the write-off would have to be against 
earned surplus. The controller disagreed with both, saying goodwill would 
have to be capitalized and written off against future earnings. 

To prove his point, the controller had prepared a memo (Exhibit 1) 
showing what Colgate-Palmolive-Peet Company had done in 1946 when 
it acquired Kay Daumit, Inc. 

The treasurer said this was only one example, and he could support 
his own view if necessary. The meeting broke up to resume at a later date. 

A few days later the treasurer brought in certain data on General 
Foods and its acquisition of Perkins Products Company, manufacturers 
of Kool-Aid, in May, 1953 (Exhibit 2). 

"See," he said, "my example is later and just as good as the con- 
troller's. " 

"Well," said the president, "apparently accounting rules and conven- 
tions will let you do anything you please. Give me a good, logical reason 
why I can't do what I prefer with our small acquisition." 



EXHIBIT 1 



Acquisition of Kay Daumit, Inc., by 
Colgate- Palmolive-Peet Company 



On November 30, 1946, Colgate- Palmolive-Peet Company acquired, through 
purchase, Kay Daumit, Inc., and Daumit Beauty Products, Inc. The agreement 
by which Colgate bought Daumit provided that $3,750,000 be paid for the goodwill, 
patents, and formulas of Daumit and $381,892 for the combined net worth (exclu- 
sive of goodwill, patents, and formulas). Part of this consideration was payable 
in cash, and part in the stock of the Colgate company. The stock to be paid to 
Daumit consisted of 37,193 shares of common stock of the Colgate company, 
valued for such purposes at the average closing price of the common stock on 
the New York Stock Exchange during November, 1946 ($47.35 per share). The 
remainder was paid in cash. 

Summary of Transaction 

Assets Acquired: 

Tangible $ 381,892 

Goodwill 3,750,000 

$4,131,892 

Payment: 

Capital Stock $1,761,089 

Cash 2,370,803 

$4,131,892 

Data from Balance Sheet of Colgate- Palmolive-Peet Company 
December 31, 1945 

Sales $135,368,000 

Net Income transferred to Surplus 7,036,000 

Total Assets 76,400,000 

Capital Stock 37,000,000 

Capital Surplus 1,800,000 

Earned Surplus 21,500,000 

Goodwill 

In its financial statements, Colgate-Palmolive- Peet Company capitalized the 
$3,750,000 of goodwill and stated that it was being written off over a ten-year 
period. 



243 



EXHIBIT 2 



Acquisition of Perkins Products Company by 
General Foods 



In May, 1953, General Foods acquired the Perkins Products Company, pay- 
ing $13,678,814 through the issuance of 249,520 shares of capital stock of General 
Goods. Of the amount of $13,676,814, the company immediately wrote off the por- 
tion assigned to intangibles ($6,237,000) against earned surplus. 

Summary of Transaction 

Purchase Price $13,676,814 

Capitalized $ 7,439,814 

Intangibles Written off at Date of Acquisition .... 6,237,000 

$13,676,814 

Data from Balance Sheet of General Foods 
March 31, 1953 

Sales $755,919,000 

Net Income transferred to Surplus 24,807,000 

Total Assets 219,016,000 

Capital Stock 142,795,000 

Earnings Retained in the Business 76,222,000 

Trademarks, Patents and Goodwill 1 



244 



, 



CASE 32 



International Trading 

and Investment Corporation 



E 



arly in August 1959, Mr. Charles M. Cooper, con- 
troller of the International Trading and Invest- 
ment Corporation (ITI) of Boston, Massachusetts, arranged an informal 
meeting with Mr. Dudley Hainsworth, a representative of ITI's firm of 
certified public accountants; Mr. Willett F. Clarke, a member of ITTs 
Acquisitions Committee; and Mr. George N. Abrahams, controller of the 
Blake Electronics Corporation of New York. Mr. Coopers purpose was 
to discuss the policy that ITI should adopt with regard to the possible 
amortization of the $3,035,000 that it had paid as goodwill in the acquisi- 
tion, on July 31, 1959, of Blake's net assets and business. The purchase 
consideration had been 116,000 shares of ITI common stock, valued at 
$39 per share, its average price on the New York Stock Exchange during 
the period of the purchase negotiations (or $4,524,000 in all). (1958 Fi- 
nancial Statements and other data for ITI are shown in Exhibits 1 to 3, 
and for Blake in Exhibits 4 to 6.) The purchase agreement warranted 
that no substantial change had taken place in the composition of Blake's 
assets and liabilities between December 31, 1958, and the date of sale, 
other than the accumulation of the current year's profits to date of 
$284,000 after taxes, represented by additions to current assets, mainly 
cash. 

Mr. Cooper had been one of ITI's representatives in the purchase 

245 



246 International Trading and Investment Corporation 

negotiations. He felt that the amount of $3,035,000 (the excess of the 
purchase price over the book value of the net assets acquired) could 
only be ascribed to intangible goodwill, and not to any appreciation of 
Blake's assets over book value. In effect, this goodwill reflected Blake's 
superior earning power, as the purchase price had basically been de- 
termined as a nine-times multiple of its projected annual after-tax earn- 
ings base of $500,000. In their investigations the ITI management had 
established that Blake's tangible assets and its liabilities were fairly stated 
on its books. It was beyond the realm of possibility that an appraised 
revaluation of Blake's fixed assets (the only assets capable of large-scale 
revaluation) could account for any significant portion of the "excess" 
purchase price. 

EARLY HISTORY 

ITI was incorporated in 1875 as the Martin Trading Company. The 
founder, Mr. Desmond C. Martin, was a well-known and highly respected 
Boston banker, and a member of one of the oldest New England families. 
His intention was to take advantage of the rapid commercial growth and 
vast natural resources of both the United States and the Canadian prov- 
inces. However, he was in no haste to speculate in any way. He would 
start the company in a new line of business only after the most exhaustive 
inquiries. This thoroughness, coupled with his native shrewdness and 
conservatism, was one of the reasons for the success of his new business 
ventures. 

By 1945, a business that had started on a relatively small scale, and 
with only modest capitalization, had grown into a giant enterprise. Over 
the years the company had followed a regular policy of reinvesting a 
portion of its net earnings. In recognition of this, there had been a num- 
ber of substantial stock dividends. In addition, occasional opportunities 
had been given to stockholders to subscribe additional capital. Loan 
capital also played an important part in the company's growth. 

By its seventieth birthday in 1945, the company was very solidly estab- 
lished in a number of fields. The trading ventures had developed into 
distributing companies with offices in both the United States and Canada. 
The manufacturing investments made through the years had all grown 
with the economy. The West Coast headquarters had even established 
trade ties with several Far Eastern countries. Foreign investments had 
followed, often in equal partnership with foreign investors. 

POSTWAR DEVELOPMENTS 

In his postwar planning, the president, Mr. Derek J. Hudson, was de- 
termined to maintain the company's solid conservative reputation, but at 



International Trading and Investment Corporation 247 

the same time wanted to continue to diversify the company's activities. 
After giving the matter due consideration, he presented a series of pro- 
posals to the board of directors in 1950. First, he recommended that the 
name of the company be changed to the International Trading and In- 
vestment Corporation, to give recognition to the broad and far-reaching 
scope of the company's activities. Second, he recommended that steps 
be taken to have the company's stock listed on the New York Stock Ex- 
change, as it seemed advantageous to create a public market for the stock. 
Finally, he proposed that the company give its attention to the rapidly 
growing electronics industry in the United States. He felt that this in- 
dustry offered unlimited scope for some very sound investments. It was 
his hope that the company would one day achieve a prominent position 
in the electronics field, if an early enough start were made. He felt that 
public stock ownership, with the consequent attention that would be paid 
to the company in financial circles, would enhance the company's ability 
to raise the possibly substantial amounts of loan capital required to 
finance the new program. 

Mr. Hudson's proposals were accepted. The stock listing was com- 
menced in July 1951, after a number of secondary stock offerings had 
been made out of the controlling stockholders' holdings, in order to gain 
wider public ownership of the stock. 



INVESTMENTS IN THE ELECTRONICS INDUSTRY 

Up to 1952 the company's policy had been, by and large, to set up 
the facilities it needed whenever it moved into any new field. There 
were obvious advantages to this policy being continued in the new elec- 
tronics division. At the same time, the directors decided that they would, 
however, consider the acquisition of suitable electronics companies as 
going concerns, if the intangibles that would be acquired merited the 
purchase. They were thinking in terms of technical experience, proven 
research and processes, and patents, all of which would take time to 
build up if the division were to start from scratch. Therefore, a dual 
policy was followed. Several important acquisitions were made in the 
following seven years. 

The Blake Electronics Corporation was one of the most important com- 
panies acquired. The founder of the company had developed a highly 
profitable business, based mainly on his highly superior electronics en- 
gineering abilities, rather than on massive capital investment. Part of 
the deal that he made with ITI was a ten-year renewable service con- 
tract, under which he would devote all his energies to the Blake division, 
with a salary guaranteed at not less than he had drawn previously. Under 
these circumstances, the directors of ITI were confident that the Blake 



248 International Trading and Investment Corporation 

division stood a good chance of remaining at least as profitable as it had 
been when run independently. An annual after-tax return of at least 
$500,000 was regarded as a reasonable expectation (refer to earnings 
record, Exhibit 6). 



SOME ACCOUNTING POLICIES 

The Martin Company's conservatism was nowhere more evident than 
in its accounting policies. The company's founder had believed that the 
utmost caution should be observed in the preparation of financial state- 
ments. He felt that this could only redound to the long-run benefit of 
the stockholders, who at that time were mainly members of his family 
and close business associates. 

This attitude was continued even after the general public obtained an 
interest in the company in 1951. The management of the company was 
fully aware of the attitudes of the Martin family and their associates. 
They felt that the added element of responsibility to outside shareholders 
further justified conservative accounting. As Mr. Derek J. Hudson him- 
self said in 1951, in the course of a discussion with the company's newly 
appointed certified public accountants: "Despite our conservatism, and 
perhaps because of it, this company has grown and prospered. We are 
very proud of the reputation we have in Boston financial circles. There 
has never yet been any move to liberalize our policies in order to show 
better results. I like to feel that our conservatism is a rock, or an anchor, 
a built-in stabilizing influence against temporary downturns. We know 
that our stockholders will never feel that we have been painting too 
bright a picture." 

Close analysis of ITI's annual financial statements revealed several ex- 
amples of conservatism. Among them was the recognition of the income 
of subsidiary companies excluded from ITI's consolidated statements be- 
cause of the nature of their operations. (Their figures were not combined 
with ITI's; ITI's interest was shown as "investments in subsidiary com- 
panies.") The income of these companies was reflected in ITI's income 
statement only to the extent that cash dividends were received by ITI, 
despite the fact that the value of ITI's ownership was increasing annually 
by substantial amounts due to the subsidiaries' retention and reinvest- 
ment of earnings. A note to ITI's 1958 balance sheet indicated that the 
book value of ITI's equity in these companies was over $24 million at 
December 31, 1958, compared with the cost at which the investments 
were carried, of under $9 million. 

A further example of conservatism was noticeable in the treatment of 
expenses incurred by the company in a small gas exploration venture 
started in 1957 in Alberta, Canada. Despite their faith in the eventual 



International Trading and Investment Corporation 249 

success of the exploration program, the directors decided to charge off 
annually all development expenses incurred. The amounts written off in 
the years 1957 and 1958 were $1.2 million and $2 million, respectively; 
no strikes had been made by December 31, 1958. 

TREATMENT OF GOODWILL 

Mr. Cooper had had to resolve the problem of amortization of good- 
will before, but the amount involved had never been so large. As the 
meeting got under way, he summed up his own attitude as follows: "I 
don't like it. Never mind what reasons there are for our having paid it, 
like patents, or earning power, or what-have-you. The fact is that there 
are no real, physical, tangible assets to show for the money. I don't think 
it's right to give goodwill a permanent home on any balance sheet. I say, 
if it's not there, it can't come back at you. When it's written off there can 
never be any disputes about how we ought to value it, or what its life is, 
or anything. So I would like to see a quick write-off. After all, our profits 
can stand it." [See Exhibit 3 for ITI's nine-year financial summary.] 

At this point there was an interjection from Mr. Abrahams, Blake's 
controller: "I know you don't let income tax regulations influence your 
judgment, Charles. However, we all know that amounts written off as 
goodwill are not an allowable deduction for tax purposes, because there 
is no way of determining its 'useful life,' as there is, for example, in the 
case of machinery. 

"In effect, this means that goodwill write-offs come out of after-tax 
profits. So if we wrote off this $3,035,000 over five years, the write-off 
would more than absorb the after-tax net we expect from Blake. If we 
use 10 years, we absorb more than half. Is this realistic? Is it fair to us 
at Blake? This could mean that there would not be any substantial con- 
tribution to profits by Blake for quite some time. And yet, if we use a 
period, let's say, of fifteen or twenty years, I suppose we would be cast- 
ing ITI's tradition of conservatism to the winds. 

"Frankly, I don't see how you can reconcile your conservatism with the 
price you paid for Blake— although my personal opinion still is that you 
made a good purchase." 

Mr. Hainsworth, the CPA at the meeting, had just recently been placed 
on the ITI account, and he asked Mr. Cooper to give him some examples 
of previous treatment of goodwill. "Well," said Mr. Cooper, "I recall that 
this kind of thing first came up back in 1951, when we made our initial 
acquisition in the electronics industry. There was about $800,000 in the 
purchase price for goodwill, maybe a little more. Seemed to me that an 
annual write-off of $100,000 would be a nice round figure, and would 
get rid of the goodwill pretty quickly. So that's what we did. 

"Next time around, it was a small distributor that we bought. Paid 



250 International Trading and Investment Corporation 

the man $40,000 for goodwill, mainly because he had pretty good cus- 
tomers. Nevertheless, we wrote it all off in the year of acquisition. Much 
easier that way. 

"It's been the same, pretty much, all along. Sometimes I take five years, 
if I'm not too happy about the company, or if it looks as if the company 
is in a tough competitive situation, or is vulnerable in some way. On the 
other hand, I did fix a twelve-year period a year or two ago, when we 
bought a very sound, well-established company that we were able to 
integrate into our own operations right away." 

"But take Blake . . ." began Mr. Abrahams. 

"Certainly. I'd be glad to," interrupted Mr. Hainsworth, who was 
known for his sense of humor. 

"Exactly!" Mr. Abrahams went on. "I think Blake is a little gold mine. 
As I said before, ITI got a bargain, at nine times earnings. Most any 
investor would pay, oh, twelve times earnings for a strong little company 
like Blake, with its growth prospects. What I'm getting at is this, that 
I think that its superior earning power definitely has a money value, even 
though it's an intangible asset. Charles, I think that this is where you 
might really consider a long-term write off, because Blake's such a sound 
investment." 

"I'm sorry, George," Mr. Cooper replied. "What if Blake should fizzle 
out after five years? Or look at it another way. Would the remaining 
unamortized goodwill lose some of its value if Blake settles down to a 
net of only $300,000? Seems to me that both of these would require some 
kind of recognition in our financial statements— and that would be recog- 
nition that we had made a mistake. Couldn't we just avoid the possibility 
of this sort of thing happening by adopting a fast write-off policy now, 
this year? The trouble with your non-conservative attitude is that at this 
stage we can't reaily tell how Blake is going to fit into our over-all opera- 
tions. We're still expanding fast in electronics. Could be that in five years' 
time the Blake division is producing a completely different range of prod- 
ucts, newly developed. What about the goodwill then? Will it just have 
disappeared? Should we write it off if this happens, because the goodwill 
that we bought won't be earning us anything? Gentlemen, I'm confused." 

"Perhaps it might be helpful if I mentioned the position taken by the 
American Institute of CPA's," suggested Mr. Hainsworth. "They recom- 
mend that intangible assets having a limited life be charged off systemati- 
cally over that life. However, they recognize that intangibles may be 
subjected to a systematic write-off even if there are no immediate indica- 
tions that their life is limited. The purpose in writing off an intangible 
with a limited life, of course, is simply to recognize that an income state- 
ment matches applicable costs (such as the expiration of any asset with 
a limited life) against revenues produced. I guess that writing off the 
other kind— those with unlimited life— is just being conservative." 



International Trading and Investment Corporation 251 

"Quite frankly, I see a different approach altogether," added Mr. 
Clarke, the fourth participant in the meeting ( ITI Acquisitions Commit- 
tee). "I, too, have every faith in Blake. In fact, I think it's going to earn 
us plenty more than $500,000 a year, in time. And I agree that an outside 
investor would easily have valued it at twelve times earnings, rather than 
the nine times we paid. I think we'd be quite conservative to value Blake, 
in total, at $6 million which is twelve times current earnings. This would 
mean that goodwill would stand at roughly $4,500,000, which I think is 
a truer evaluation of its real worth. 

"And there's another thing. Take a look at the format we use for our 
published income statement [Exhibit 2]. There's no real detail there. 
Nobody will ever be able to tell from looking at it that we've charged this 
goodwill off, if we do. So why don't we just forget about writing it off? 
I think George would agree with this. That goodwill's worth every penny 
of $4,500,000-let's leave it at that on the books." 



Required 

1. How should the Blake goodwill be valued? Is Mr. Clarke's approach to its 
valuation valid? 

2. What policy should ITI adopt with regard to the writing off of the Blake 
goodwill? 

3. Appraise the usefulness of the conservatism practiced in ITI's accounting 
up to the date of the case. 



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252 



EXHIBIT 2 



Consolidated Income Statement for the Year 
Ended December 31, 1958 



Income: 

Sales and other operating revenue items $395,153,000 

Interest and dividends 4,178,000 

Total income $399,331,000 



Expenses: 

Operating expenses $294,799,000 

General and administrative expenses 31,612,000 

Depreciation 18,853,000 

Research and development 7,320,000 

Exploration costs— Alberta gas project 1,983,000 

Interest expense 8,547,000 

U.S. and foreign income taxes 17,703,000 

Total expenses $380,817,000 



Consolidated income less expenses $ 18,514,000 

Deduct: Outside stockholders' interest in net 

income of consolidated subsidiaries 616,000 

Net income $ 17,898,000 

Retained earnings, December 31, 1957 127,153,000 

$145,051,000 

Dividends paid in 1958 9,666,000 

Retained earnings, December 31, 1958 $135,385,000 



253 



EXHIBIT 3 


Financial Summary, 

Sales and Other 

Operating 
Revenue Items 

$202,128,000 


1950-1958 

Net Earnings 
(After Taxes) 

$ 7,350,000 






Total 

Dividends 

Paid 


1950 


$ 5,125,000 


1951 


267,927,000 


8,998,000 


5,530,000 


1952 


287,185,000 


7,771,000 


5,297,000 


1953 


301,192,000 


11,453,000 


5,791,000 


1954 


376,196,000 


13,462,000 


6,764,000 


1955 


338,630,000 


17,090,000 


8,584,000 


1956 


398,705,000 


18,004,000 


9,886,000 


1957 


408,352,000 


18,068,000 


10,437,000 


1958 


395,153,000 


17,898,000 


9,666,000 



EXHIBIT 4 



Blake Electronics Corporation- 
Balance Sheet at December 31, 1958 



Current assets: 

Cash 

Accounts receivable 

Inventories, at lower of cost and market 
Prepaid insurance 



532,000 

976,000 

585,000 

10,000 



Total current assets $2,103,000 



Property, plant and equipment (net) 
Other assets 



813,000 
21,000 

$2,937,000 



Current liabilities: 

Accounts payable $1,419,000 

Accrued expenses 50,000 

Federal income taxes 263,000 

Total current liabilities $1,732,000 

8% Preferred stock, $100 par $ 60,000 

Common stock, $10 par 2,000 

Retained earnings 1,143,000 

Total stockholders' interest $1,205,000 

$2,937,000 



254 



EXHIBIT 5 



Blake Electronics Corporation— Income Statement 
for the Year Ended December 31, 1958 



Net sales $7,505,000 

Cost of sales 6,032,000 

Gross profit $1,473,000 

Operating expenses: 

Selling $ 261,000 

Administration 222,000 

$ 483,000 

Operating income $ 990,000 

Other income (net) 2,000 

Income before federal income tax $ 992,000 

Federal income tax 516,000 

Net income $ 476,000 



Statement of Retained Earnings 
for the Year Ended December 31, 1958 

Balance at January 1, 1958 $1,017,000 

Net income 476,000 

$1,493,000 

350,000 



Dividends paid in 1958 _ 

Balance at December 31, 1958 $1,143,000 



EXHIBIT 6 



Blake Electronics Corporation - Analysis of 
Retained Earnings, December 31, 1958 





Earnings 

After Tax 

(Loss) 

$( 47,000) 


Dividends 
Paid 


Retained Earnings 
Balance, Dec. 31 
(Deficit) 


1949* 


- 


$ ( 47,000) 


1950 


(101,000) 


- 


(148,000) 


1951 


19,000 


- 


(129,000) 


1952 


168,000 


- 


39,000 


1953 


342,000 


$150,000 


231,000 


1954 


446,000 


220,000 


477,000 


1955 


462,000 


250,000 


689,000 


1956 


487,000 


300,000 


876,000 


1957 


491,000 


350,000 


1,017,000 


1958 


476,000 


350,000 


1,143,000 



♦The company was incorporated in March 1949 and commenced business the 
following month. 



255 



CASE 33 



Miller 

Salt Company 



i 



n February 1961 Mr. Morgan Nicholas, president of 
Miller Salt Company, 1 was confronted with the 
problem of deciding how the newly acquired assets of Caribou Valley 
Salt Company 1 should be shown on Miller's balance sheet. He had held 
several conferences with his own executives, agents from the Internal 
Revenue Service, and representatives of the American Appraisal Com- 
pany, but in the final analysis, he was the only one who could make this 
important decision relative to asset valuation on the company's balance 
sheet. Since Miller's fiscal year had ended on December 31, 1960, Mr. 
Nicholas knew he must come to his final decision very soon. Because of 
this deadline, he decided to devote the rest of the day to reviewing, 
analyzing, and pondering the results of his decision to acquire Caribou 
Valley Salt Company. 

HISTORY OF MILLER SALT COMPANY 

The Miller Salt Company, of Detroit, Michigan, was one of the oldest 
producers of salt in the country. It was founded late in the nineteenth 
century and had grown from a small one-man operation to a large multi- 



1 Fictitious name. 

256 



Miller Salt Company 257 

plant company that accounted for from 5 per cent to 10 per cent of the 
total salt production of the United States. Selected income data for the 
Miller Salt Company are given in Exhibit 1. 

The common stock of Miller had been closely held for many years but 
because of the company's rapid growth, financing had been solicited 
from outside sources, and by 1960 the capital stock of Miller was widely 
distributed. Mr. Nicholas had been appointed president in late 1958 dur- 
ing an executive reorganization motivated by shareholder dissatisfaction 
with the company's recent growth relative to the growth of the total salt 
market. The shareholders had also expressed dissatisfaction with the com- 
pany's recent earnings record. 

Miller Salt Company had had salt-producing and refining plants in 
Michigan, New York, Pennsylvania, and Ohio, prior to its acquisition of 
the Caribou Valley Salt Company. The company's primary market em- 
braced heavy chemical industries in the North Central, Northeastern, 
and Middle Atlantic States. These chemical industries used salt in the 
manufacture of most sodium and chlorine compounds and in the pro- 
duction of petroleum products and plastics. Since most of these industrial 
consumers had branch plants in various parts of the country and because 
of the high cost of transporting salt for any great distance, Miller Salt 
Company might supply the northern branch of a company but be un- 
able to supply its western branch because of the high cost of transporting 
salt from a northern mining and refining center to a western market. 

Because of Miller's weak market position in the West and because 
many branch plants of companies, with which Miller had established 
lines of supply in the North and East, were located in the West, Mr. 
Nicholas as one of his first acts of office began negotiations to acquire an 
established market outlet in the West. He felt that such action would 
boost Miller's sales and improve its profit picture. After negotiating with 
Caribou Valley Salt Company on the basis of the value of its assets, the 
extent, strength, and brand loyalty of the Caribou Valley market, and the 
remaining recoverable deposits in the mine, Miller had acquired all the 
outstanding Caribou capital stock ( held by the Chadwick and Northland 
families) for a cash payment of $4,500,000 in January of 1960. Miller 
also assured Caribou's top executives a berth in its executive cadres if 
they so desired. 



HISTORY OF CARIBOU VALLEY SALT COMPANY 

In 1917 John Chadwick and Walter Northland, two Los Angeles, 
California, chemical wholesalers, purchased Caribou Valley, a wooded 
peninsula jutting into the Pacific Ocean near San Juan Capistrano, with 
the intention of creating a private hunting and fishing preserve for Los 



258 Miller Salt Company 

Angeles businessmen. The peninsula, 125 acres in size, was tucked deep 
in a bay and thus not only had access to the sea but also had access to 
adjacent swampland. While drilling for water to supply their lodge, 
Chadwick and Northland hit rock salt at 100 feet. Subsequent exploration 
disclosed that the peninsula was the cap of a massive rock salt deposit 
6,300 feet in diameter and several thousand feet deep. 

Roughly 15 per cent of the deposit was beneath the peninsula, but an 
additional 420 acres of developable deposit extended into the adjacent 
bay, which was owned by the State of California. A fifty-year lease of the 
state's mineral rights was secured in 1920, under which the state was to 
be paid six cents per ton of salt mined. 

Since the salt deposit came to a peak under the peninsula, Chadwick 
and Northland had to sink a shaft to an 800-foot depth before the lateral 
area of the deposit was extensive enough to permit economical mining. 
Because of this, open-pit mining ( mining from the land surface ) had not 
been feasible. At the same time, mill buildings had been constructed, 
primary and secondary crushers, classifiers, evaporators, recrystallization 
equipment, and other machinery had been put into place. The mine 
began operation in 1922 at the 800-foot level and produced 2,620,932 tons 
of salt at this level prior to 1940, when the impurity of the salt at this 
level made it desirable to extend the mining operations to the 1,000-foot 
level; subsequently, work at the 800-foot level was abandoned. After the 
installation of certain new equipment, mining commenced at the 1,000- 
foot level and 4,757,086 tons of salt had been removed from the level by 
the end of 1959 (see Exhibit 2 for tonnage summary). 

But at this point Caribou Valley Salt Company faced a dilemma. They 
had retained Wambly & Raymond, consulting geologists and mining en- 
gineers of Chicago, to determine ( 1 ) the remaining tonnage at the 1,000- 
foot level, (2) the feasibility of reworking the 800-foot level, and (3) 
the possibility of operating a third level at 1,200 feet. The engineers' re- 
port estimated that only 2,200,000 tons of rock remained at the 1,000-foot 
level ( %ths of which was on state land), that the 800-foot level had been 
"worked out" on the basis of the quality of rock salt necessary to make 
the present shaft-mining operation feasible, and that if the shaft was 
extended to the 1,200-foot level, new hoists, drive motors, and ventilating 
equipment would have to be installed to support the increased mine 
depth. The salt deposit extended down several thousand feet so the 
mineral was there but the problem existed in getting it out. The report 
also indicated that a large amount of salt would have to be left intact at 
the 1,200-foot level in order to support the weight of the salt and earth 
above the tunnels since the salt at this level had a relatively low com- 
pressive strength. At best, the report indicated that only marginal safety 
could be maintained at the 1,200-foot level. 

Mr. Chadwick and Mr. Northland, both in their late 60's, were quite 



Miller Salt Company 259 

upset over the geologists' report and because of this report and the fact 
that neither of them had heirs who were interested in running the com- 
pany, they decided to sell the company. It was at this point that Mr. 
Nicholas of Miller Salt Company negotiated the purchase of Caribou 
Valley Salt Company. 



MILLER S ACQUISITION OF CARIBOU VALLEY 

Mr. Nicholas became interested in Caribou Valley because of its strong 
penetration of the western salt market. Caribou Valley Salt Company had 
built a solid market position for its product and had been able to acquire 
many major industrial salt users in the West as its customers. It had been 
able to do this by insuring exceptional quality, by guaranteeing prompt 
delivery on short notice, and by selling for less than national competition 
because of lower freight costs relative to its closeness to the market. The 
product was considered by many industrial concerns as the finest that 
could be obtained (see Exhibit 3). 

Also, Mr. Nicholas felt that a new mining technique that was in the 
final stages of development in Miller's research laboratory could be 
profitably employed both in mining salt from depths greater than 1,000 
feet and in recovering salt from the 800-foot and 1,000-foot levels which 
had previously been considered of a quality too poor to mine. However, 
controversy existed among various mining experts as to whether or not 
this new technique would be applicable at the Caribou Valley mining 
property. Miller had no previous experience in shaft mining as all their 
mines were of the open-pit or forced-well variety. A forced-well mine 
was operated by forcing water under pressure down a pipe into the layer 
of salt. The water dissolved the salt and was then forced out another pipe 
as additional fresh water was forced into the cavity. The salt water was 
then evaporated, leaving salt behind as a residue. Mr. Nicholas was con- 
fident that even if the new mining technique did not prove operational 
at the Caribou Valley mine, Miller would still be able to purchase salt 
from other local salt mines, process it on Caribou Valley's recrystallization 
equipment, and sell it through Caribou's sales organization under the 
well-established Caribou Valley brand name. 

Aside from the operational aspects of the Caribou Valley property, 
Miller faced the problem of establishing a valuation on the assets acquired 
from Caribou Valley. This was a particularly difficult task since Miller 
had paid $4,500,000 for Caribou's total net worth of only $2,717,110 
(Exhibit 4). The difference of $1,782,890 must then have been paid for 
goodwill, for assets not shown on Caribou's balance sheet, or because 
Miller considered that Caribou's assets were worth more than the amount 
at which they were shown on the balance sheet. Mr. Nicholas, Mr. 



260 Miller Salt Company 

Jamieson (Miller's controller), and other members of the board of 
directors, felt that an appraisal by an outside consultant was necessary 
in order to properly determine the value at which the new assets should 
be carried. They also specified that only the fixed assets (property) should 
be appraised since it was their opinion that the current assets could be 
brought onto Miller's books at Caribou's book value. The notes and ac- 
counts receivable had been guaranteed collectible by Northland and 
Chadwick and the inventory of $323,780 was composed of $199,200 of 
boxed salt against which purchase orders had already been received, 
$49,800 in bags, bales, and labels which Miller expected to use immedi- 
ately in its packaging operations, and $74,780 of salt in the process of 
being recrystallized for which a ready market existed. 

Mr. Nicholas felt that a correct or reasonable property valuation was 
extremely important for three reasons: 

( 1 ) The asset valuation established would be used in determining the 
amount of depreciation allowed by the Internal Revenue Service 
and would therefore have a direct effect on the amount of profit 
remaining for Miller's shareholders after taxes. The importance of 
this item was further stressed by Mr. Schwingle of American Ap- 
praisal in his initial conference with Mr. Nicholas. ( See section on 
property appraisal.) 

( 2 ) The asset valuations would be used for casualty insurance assess- 
ments. This involved maintaining appropriate amounts of insur- 
ance as well as affecting coinsurance requirements. 

(3) Finally, the appraisal was needed for internal and external ac- 
counting purposes, that is, relation of costs to pricing, return on 
investment, extent of dividend payout or retention to provide for 
future equipment replacement, booking depreciation, and others. 
Further, Mr. Nicholas felt that since he had only recently been 
appointed president, the shareholders would be carefully scrutiniz- 
ing any figures reported in the 1960 annual report. 

Because of the importance of setting "correct" values on the assets, 
Mr. Nicholas retained the American Appraisal Company of Milwaukee, 
Wisconsin, to carry out this appraisal work. 

Exhibit 4 gives Caribou's balance sheet as compiled by Caribou's con- 
troller as of the date of acquisition. 



ORGANIZING FOR THE PROPERTY APPRAISAL 

During the initial conference which was held between Mr. Nicholas 
and Mr. Schwingle, American Appraisal's representative from the Mil- 
waukee office, Mr. Schwingle stated that he felt the paramount problem 



Miller Salt Company 261 

faced in the appraisal was that of allocating the $4,500,000 purchase price 
to the tangible and intangible, depreciable and nondepreciable assets of 
Caribou in such a way that full benefit could be taken of the 1954 Rev- 
enue Code. 

As permitted by the code, Miller could bring the acquired assets onto 
their tax books at cost, which was the price which had been paid for the 
Caribou stock. However, the code stipulated that the price paid ( cost to 
Miller) must be allocated "equitably" to all tangible and intangible 
assets acquired. The code did not allow any depreciation deduction for 
goodwill and certain other types of intangible assets. It would therefore 
be to Miller's advantage to set as high a value on depreciable assets, such 
as machinery, buildings, and office equipment, as possible, thus minimiz- 
ing the allocation to nondepreciable assets such as goodwill. 

Moreover, it would be to Miller's advantage to minimize the value 
placed on the salt deposits and the mine shaft, since the code permitted 
a percentage depletion deduction on these assets, regardless of the orig- 
inal cost assigned to them. Thus, the smaller the value assigned to de- 
pletable assets, the higher the value that could be assigned to depreciable 
assets, with no effect on the depletion deduction allowed under the code. 

Depletion was defined in the code as, "the gradual diminution of the 
original amount of a mineral deposit because of any operation which 

Example 1: Percentage Depletion Method 

Gross salt sales $4,000,000 

Cost of sales 2,000,000 

Gross profit $2^)00,000 

Less other operating and nonoperating expenses $1,000,000 

Net income before tax $1,000,000 

Less depletion deduction of 10% of gross sales (but not to 
exceed 50% of 1,000,000 or be less than $50,000 com- 
puted as the deduction under the cost of units method, 

example 2) 400,000 

Taxable income $ 600,000 



Example 2: Cost of Units Method 

Where: Original cost of salt deposit and mine shaft 

= $500,000 
Estimated tons of salt in deposit = 5,000,000 tons, there- 
fore the cost imputed to each ton mined = $500,000 
-h 5,000,000 tons = 10^ unit cost per ton mined 

Gross salt sales (500,000 tons) $4,000,000 

Cost of sales (other than cost of raw salt) 2,000,000 

Gross profit $2,000,000 

Less other operating and nonoperating expenses 1,000,000 

Net income before tax $1,000,000 

Less cost of salt computed under the cost of units method 

(500,000 tons x 10* per ton) 50,000 

Taxable income $ 950,000 



262 Miller Salt Company 

removed the mineral from its natural state. In such a case, the owner or 
lessor of the deposit is entitled to a depletion allowance of 10 per cent ( on 
salt deposits) of gross sales from the property. However, this allowance 
must not exceed 50 per cent of the property's taxable income, but may 
not be less than the deduction computed under the cost of units method/' 
Once a company had adopted either of these methods, it was committed 
to this method and could not elect to change from one to the other. Under 
the cost of units method, the cumulative total of the annual cost re- 
coveries ( $50,000 in the example ) was not allowed to exceed the original 
purchase price ($500,000 in the example); whereas under the per- 
centage depletion method, the original purchase price had no bearing 
on the amount allowed as a depletion deduction. 

Mr. Schwingle further pointed out, "The task cannot involve setting 
unrealistically high valuations on property units with the sole purpose 
being to allocate the entire purchase price to depreciable assets, but it 
must involve identifying all depreciable assets and establishing a sup- 
portable value thereon. The appraisal must exhibit high-level professional 
integrity in order to make the allocation acceptable to the Internal Rev- 
enue Service." 

After an estimated appraisal fee of $25,000 had been agreed upon, 
American's field dispatch unit assigned three men from its structural de- 
partment to appraise the buildings, four men from the mechanical de- 
partment to evaluate machinery and equipment, and two men to study 
the land. Several additional men were assigned to do research on special 
projects such as leasehold improvements, lease and royalty contracts, 
and costs and operation methods at other competitive salt mines in vari- 
ous geographical areas. The final results of the appraisal have been 
reproduced as Exhibit 5. This exhibit indicates for each major asset 
item: (1) original cost, (2) accumulated depreciation to December 31, 
1959, on Caribou's books, (3) net book value on Caribou's books, (4) 
"cost of reproduction new," (5) fair market value, and (6) the assets' 
estimated remaining life. 

PERFORMANCE OF THE PROPERTY APPRAISAL 

In general, the American Appraisal Company structured its appraisal 
operation as diagrammed in Exhibit 6. Specifically, in appraising the 
assets of Caribou Valley Salt Company, American's engineers were con- 
fronted with four major tasks: 

1. To identify all tangible and intangible, depreciable and nondepre- 
ciable assets of Caribou Valley. 

2. To establish the "cost of reproduction new" of each of these assets. 
Cost of reproduction new was the amount that would be required to 
fully recreate an asset in its original condition at today's costs. This figure 



Miller Salt Company 263 

became a partial bench mark for calculating present values after physical 
depreciation and functional obsolescence were considered. 

In setting the cost of reproduction new for Caribou's land, American's 
field appraisers checked sales of similar salt properties within California 
and in other parts of the nation. In the selection of these comparable 
land sales, several conditions had to be present if they were to have 
validity. The sales had to occur, for example, in a reasonably free market 
with willing sellers and willing buyers. There must have been equity to 
both parties to the sale and both parties must have had equal access to 
the facts about the property. Finally, there must have been time for full 
market exposure of the property. Once the comparable sales data were 
collected, the appraisers made adjustments to eliminate circumstances 
peculiar to each sale so that they would become truly comparable to the 
Caribou case. 

In establishing the cost of reproduction new of the mine shaft, the 
canal, and the buildings, American's appraisers determined what ma- 
terials in what quantities, what input of labor, what overhead expenses, 
and what other elements of cost would be required to rebuild each of 
these facilities new at the date of the appraisal. Information to support 
these cost findings was obtained partially from American's architectural 
and structural pricing library at Milwaukee and partially from checks 
with contractors, labor unions, and materials suppliers in the Caribou 
Valley area. 

The mechanical valuation engineers who worked on cost of reproduc- 
tion of machinery and equipment relied heavily on American's mechanical 
pricing library at Milwaukee, but checks were also made with equipment 
manufacturers. Perhaps most important, the mechanical men were spe- 
cialists in mining equipment and familiar with the machinery and its 
characteristics. 

The cost of reproduction new for office furniture and fixtures and auto- 
mobiles and trucks was determined in a manner similar to that for ma- 
chinery and equipment described immediately above. 

The salt deposits were valued with the aid of consulting geologists who 
calculated the remaining mineable tonnage at the 800- and 1,000-foot 
levels. American's appraisers then figured the cost of recovery, royalty 
payments for salt in the state lands, royalty savings on the owned lands, 
processing, and other costs in setting value. No value was assigned salt 
below the 1,000-foot level because its recovery was speculative and be- 
cause its development would not occur for at least ten years. Precisely 
what cost and mining conditions would be realized in several years could 
not be known at the time of the appraisal, and consequently, no sup- 
portable value could be given the lower deposits. 

Preliminary field values were sent to American's Milwaukee office 
where they were checked, calculated, and extended. 



264 Miller Salt Company 

3. To establish the fair market value of the assets. Fair market value^- 
the figure that would be equivalent to current book value— was not neces- 
sarily cost of reproduction less accrued depreciation with provision for 
functional obsolescence, nor was it the amount that would be obtained in 
the used machinery and equipment market. Fair market value in this 
case, Schwingle reasoned, would be the value of the assets as part of a 
going concern. 

The hoist and cage equipment in the mine shaft, for example, were old, 
and no mining company would install such equipment today. If offered 
in the used equipment market, the hoist and cage would probably have 
little more than scrap value. Yet they had been well maintained and 
were functional. To Caribou Valley, therefore, the equipment had value 
as part of the enterprise substantially above scrap and used equipment 
value. The fair market value as determined by American was cost of 
reproduction less accrued depreciation from all causes, less a penalty for 
the slight inefficiency and added operating cost induced through use of 
this equipment as opposed to more modern machinery. 

On the other hand, the current used automobile market was used as 
a base in determining fair market value for automobiles, since used autos 
were exchanged freely between sellers and buyers without consideration 
of their value as part of the enterprise. 

4. To establish remaining useful lives of the assets. In determining the 
remaining useful lives of the buildings, machinery, and equipment, mine 
shaft, canal, office furniture and fixtures, and automobiles and trucks, 
American's valuation engineers relied heavily on their judgment about 
the assets and sought to determine the amount of time remaining before 
each asset would either exhaust its useful life because of wear and tear 
or become functionally obsolete. In the case of power shovels and muck- 
ing machines used in the mine, the appraisers knew that their physical 
lives would extend several years beyond the time at which new equip- 
ment would make them functionally obsolete, and the estimated date of 
functional obsolescence was therefore used to set the remaining lives on 
these pieces of machinery. 

In setting a thirty-five-year life on the canal, American's engineers esti- 
mated the time that would elapse before silting and slippage would re- 
quire redredging equivalent to a complete rebuilding of the canal. 

The remaining useful lives established varied from asset to asset and 
in American's Milwaukee office as the final report was given executive 
review, argument developed because the lives of several assets were 
longer than the estimated life of the sale deposits. "If the salt gives out 
in ten years," Mr. Gaus, a field review man, argued, "what earthly value 
have the buildings, the machinery, and the mine shaft?" Schwingle re- 
plied that although the salt below 1,000 feet had not been valued and 
had been given no life, a new process which was in the final stages of 



Miller Salt Company 265 

development at Miller might permit its exploitation. Besides, he con- 
tinued, the surface works could be used to process salt from other near- 
by sources. 

In final executive review at Milwaukee, a determination had to be 
reached as to whether the total appraised value could be supported by 
the anticipated profits that the business would earn. Based on experience 
of the five prior years, and without attempting an income forecast, the 
valuation study indicated that a profit of approximately 10 per cent on 
the investment (after taxes and depreciation) could conservatively be 
anticipated annually over the next ten years. The annual aggregate 
weighted depreciation, if figured on a straight-line basis, was given at 
8.37 per cent. When combined, the profit on the investment and the re- 
covery of the investment yielded an annual cash flow of 18.37 per cent. 
This figure was high enough to justify the purchase price and the fair 
market value established by the apparisal, and it compared well with 
comparable rates gathered in analysis from ten other similar mining 
companies. 



INTERNAL REVENUE SERVICE REACTION TO PROPERTY APPRAISAL 

Miller Salt Company submitted American's appraisal of its acquired 
assets to the I.R.S. for a ruling to reasonability. In a subsequent confer- 
ence, which was held with two I.R.S. agents, the I.R.S. contested the 
valuation placed on the following items: 

(1) Valuation of Salt Deposits— The I.R.S. agents contended that the 
ten-year estimated life was unrealistic, and in their opinion the 
life should be some indefinite period. They also contended that 
the value of the deposits should be $850,000 rather than the 
$273,900 as proposed by the American Appraisal Company. 

(2) Value of Mine Shaft- It was Mr. Howe's (I.R.S. agent) opinion 
that the "hole in the ground" had not decreased in value since its 
inception, and because Americans appraisal set the cost of repro- 
duction for the entire shaft including shorings at $1,141,250, Mr. 
Howe believed the value of the hole should be related to that 
amount. The I.R.S. did not consider the mine shaft as a depreciable 
asset but ruled that it was depletable property and therefore no 
depreciation could be allowed on the shaft itself. From this, he 
contended that the fifteen-year life set on the shaft was completely 
erroneous. 

(3) Canal— Why should a canal be considered as a depreciable asset? 
Mr. Howe contended that a canal was similar to land and therefore 
no depreciation could be claimed. 

(4) Inconsistency of Estimated Lives— Why weren't the various valua- 



266 Miller Salt Company 

tions based on a single consistent term, say ten years, the date 
when the state lease was to expire? Mr. Howe stated that it was 
inconsistent to assign salt deposits a ten-year life, the mine shaft a 
fifteen-year life, buildings an eighteen-year life, and so on. Mr. 
Howe further commented that in light of the inconsistencies, the 
eighteen-year life of the building was far too short a time. At this 
point Mr. Nicholas had charged Mr. Howe with being inconsistent 
in his criticism of inconsistency. Mr. Howe replied that he did not 
intend to imply that he or the I.R.S. would have accepted Ameri- 
can's estimated lives even if a consistent ten-year term had been 
used. 

No final agreement had been reached with the I.R.S. agents on any of 
the above items, but a second meeting had been scheduled. Legal counsel 
for Miller Salt Company said that negotiations with the I.R.S. might con- 
tinue for several months and perhaps longer if the company decided to 
challenge the final I.R.S. decision in the tax courts. In the lawyer's 
opinion, Miller's tax position would not be unduly prejudiced if the com- 
pany handled the transaction differently for book ( stockholder-reporting ) 
purposes because differences between tax and book treatments were 
common, particularly for companies permitted to deduct depletion al- 
lowances for tax purposes. 

reaction of miller salt company executives 
to American's property appraisal 

As Mr. Nicholas contemplated what decision he should make relative 
to the valuation of the acquired property assets on Miller's books, he 
mulled over the points of view expressed by various members of Miller's 
board of directors at a meeting where the acquisition of Caribou Valley 
had been the topic of discussion. 

Mr. Jamieson, Miller's controller, advocated the use of Caribou's book 
values, as of the date of acquisition, as the basis at which the acquired 
property should be carried. He agreed that for tax purposes the appraised 
values should be used, but he contended that the assets weren't worth 
any more to Miller than they had been to Caribou, and thus the book 
value ($1,221,346) of the property assets should be shown on Miller's 
books. He admitted that his method might be on the conservative side, 
but that this was far superior to using appraisal values which had obvi- 
ously been stated at a maximum for income tax purposes. He commented, 
"American's appraisal is absolutely silly. They say that the assets we 
purchased are worth more than we paid for them ($3,407,605.56 ap- 
praised property + $2,196,181.00 current assets - $769,254.00 current lia- 
bilities = $4,834,532.56 net worth purchased for $4,500,000), and this in- 



Miller Salt Company 267 

dicates to me that American arrived at inflated asset values. This is fine 
for our tax books, but isn't it misleading to management and to our 
stockholders?" He thought that the difference between the purchase price 
and the total asset book values should be written off as an extraordinary 
loss of the period, but justified in the annual report on the basis that such 
a loss was necessary to the establishment of a foothold in the western 
market. This idea had not appealed to Mr. Nicholas because he was afraid 
that the shareholders would become quite perturbed if a large acquisition 
loss appeared on the first income statement after he had become presi- 
dent, regardless of what justification he gave. 

Mr. Crowder, a director of Miller and partner in a local stock brokerage 
house, stated that he saw no reason why the assets should not be shown 
at their appraised values. After all, he pointed out, "We hired the Ameri- 
can Appraisal Company to evaluate our assets, and if we can't rely on 
their judgment and values which have been meticulously determined, 
we had better give up. There is absolutely no justification for tinkering 
around with the values they arrived at." He further pointed out that the 
shareholders were interested in the actual realistic values of the assets 
which had been purchased, and not in some meaningless book value as 
determined by Caribou's bookkeeper. "The book value shown on Cari- 
bou's balance sheet has absolutely no relevance in determining the asset 
values which we should show on our books," was his concluding remark. 

Finally, Mr. Jevelekian, vice president of marketing, had disagreed 
violently with this approach and told Mr. Crowder that he had evidently 
forgotten the prime reason for purchasing Caribou in the first place. He 
reminded the board that the prime reason for purchasing Caribou had 
been to acquire its western market and brand image and not for the value 
of the mining assets themselves. He agreed with Jamieson that the assets 
acquired should be shown at book value, not at appraised value, but that 
the difference between the purchase price and book value should be 
shown as the value of the markets and customer lists which had been 
built up under the Caribou Valley brand name and for which the com- 
pany had been acquired. He even went one step further than Jamieson 
when he said, "For that matter, we could disregard the value of the 
assets completely and could allocate the entire purchase price to Value of 
markets acquired' which would then be shown as a permanent asset on 
our balance sheet. Isn't this the most accurate presentation of the facts, 
since we don't know that further mining of salt is possible even with our 
new method?" 

After mulling over each of these points of view, after considering the 
comments made by the I.R.S. agents after their examination of Americans 
appraisal, and with American's appraisal before him, Mr. Nicholas 
thought he could now decide on a course of action relative to valuation 
of Caribou's property assets which he felt would be reasonable. 



EXHIBIT 1 



Comparative Income Statistics 
(All values given in thousands) 



Miller Salt Company 





Net Sales 


Net Income 


Dividends Paid 


1950 


7,271 


$ 913 


$ 448 


1951 


8,840 


1,058 


498 


1952 


9,109 


979 


498 


1953 


8,898 


872 


498 


1954 


10,275 


2,208 


797 


1955 


10,956 


1,992 


996 


1956 


12,035 


2,108 


1,096 


1957 


11,703 


1,743 


1,096 


1958 


12,450 


1,735 


946 


1959 


12,915 


1,660 


946 


Caribou Valley Salt Company 










Net Sales 


Net Income 


Dividends Paid 


1950 


1,743 


$220 


N.A. 


1951 


2,075 


232 


N.A. 


1952 


2,457 


221 


N.A. 


1953 


2,158 


206 


NA. 


1954 


2,615 


249 


NA. 


1955 


1,834 


156 


-NA. 


1956 


2,125 


191 


NA. 


1957 


2,507 


237 


NA. 


1958 


2,817 


277 


N.A. 


1959 


3,514 


520 


N.A. 



EXHIBIT 2 



Salt Production of the Caribou Valley Salt Company 
(In tons) 







Source 




Total 


Year 


Caribou Owned Land State Leased Land 


Production 


1959 


15,874 




432,723 


448,597 


1958 


13,018 




311,403 


324,421 


1957 


6,402 




283,079 


289,481 


1956 


34,375 




205,207 


239,582 


1955 


80,097 




132,675 


212,772 


1954 


168,682 




130,343 


299,025 


1953 


165,734 




82,652 


248,386 


1952 


146,346 




98,836 


245,182 


1951 


156,953 




79,033 


235,986 


1950 


170,963 




66,749 


237,712 


1922-1940 800-foot 










level 


N.A. 




N.A. 


2,620,932 


1941-1959 1,000-foot 










level 


N.A. 




N.A. 


4,757,086 


Total production 










1922-1959 


NA. 




N.A. 


7,378,018 



268 



EXHIBIT 3 



Comparative Statement of Income of Caribou Valley 
Salt Company for the Periods Ended 31 December 
1959 and 1958 







1959 


% 




1958 


Jl 


Increase 
Decrease 


Tons sold 




442,075 






323.693 




118,382 


Gross sales 


. . $2 


,530,763 

16,532 

.514.231 


100.0% 


$2,825,306 

8,382 

$2,816,924 


100.0% 


$705,457 


Less adjustments 

Net sales 


. . $3 


8,150 
$697,307 


Cost of sales 


. . 1,797,896 


51.2 


1,607,156 


57.1 


190,740 


Gross profit 


. . $1,716,335 


48.8% 


$1,209,768 


42.9% 


$506,567 


Operating expenses: 

Selling 

Administrative 




499,250 
399,989 
899,239 


14.2 
11.4 

25.6% 


$ 


500,595 
322,548 
823,143 


17.8 
11.4 

29.2% 


$ -1,345 
77,441 




. . $ 


$ 76,096 


Gross profit from operations . . . 


.. $ 


817,096 


23.2% 


$ 


386,625 


13.7% 


$430,471 


Other income credits: 

Total income credits 


. . $ 


55,801 
872,897 

57,769 


1.6% 
24.8% 


$ 

$ 


18,761 
405,386 

7,016 


.7% 
14.4% 


$ 37,040 
$467,511 

$ 50,753 


Gross income 


. . $ 


Total income charges 


. . $ 


1.6% 


$ 


.3% 


Net income before provision for 

income taxes 

Provision for income taxes 

Net income after provision for 

income taxes 


. • $ 
. . $ 


815,128 
294,567 

520,561 


23.2% 
8.4 

14.8% 


$ 
$ 


398,370 
120,975 

277,395 


14.1% 
4.3 

9.8% 


$416,758 
173,592 

$243,166 







269 



EXHIBIT 4 



Comparative Balance Sheet of Caribou Valley 
Salt Company, 31 December 1959 and 1958 



Increase 

ASSETS 1959 1958 Decrease- 
Current assets: 

Cash $1,051,701 $ 825,340 $226,361 

Notes and accounts receivable: 

Customers 800,559 458,042 342,517 

Sundry 24,291 18,118 6,173 

Total notes and accounts receivable $ 824,850 $ 476,160 $348,690 

Less reserve for doubtful accounts 4,150 4,150 

Net notes and accounts receivable $ 820,700 $ 472,010 $348,690 

Inventories 323,780 298,647 



Total current assets $2,196,181 $1,595,997 $600,184 

Property: 

Land $ 70,665 $ 7,055 $ 63,610 

Salt deposits- arbitrary constant $ 100,000 $ 83,000 $ 17,000 

Shaft construction and developments 309,971 309,971 

Total depletable property $ 409,971 $ 392,971 $ 17,000 

Less reserve for depletion 282,641 277,375 5,266 

Net depletable property $ 127,330 $ 115,596 $-11,734 

Buildings, machinery, and equipment $2,351,791 $2,278,636 $ 73,155 

Automobiles and trucks 62,302 73,310 -11,008 

Furniture and fixtures 51,780 54,299 - 2,519 

Canal development 47,717 47,717 

Total depreciable property $2,513,590 $2,453,962 $ 59,628 

Less reserve for depreciation 1,520,341 1,502,181 18,160 

Net depreciable property $ 993,249 $ 951,781 $ 41,468 

Construction in progress $ 30,102 $ 21,703 $ 8,399 

Net property $1,221,346 $1,096,135 $125,211 

Intangible assets: 

Rights of way $ 747 $ 747 

Deferred charges: 

Prepaid insurance 59,002 

Dissolver expense 4,262 

Other 4,826 

Total deferred charges $ 68,090 

Total assets $3,486,364 

LIABILITIES AND NET WORTH 
Current liabilities: 

Vouchers payable $ 267,746 

Dividends payable 

Accrued taxes 314,016 

Other accrued accounts: 

Salaries and wages $ 10,762 

Bonuses and commissions 146,882 

Miscellaneous accrued accounts 29,848 

Total other accrued accounts $ 187,492 

Total current liabilities $ 769,254 

Net worth: 

Capital stock: 

Common— authorized, 50,000 shares without par 

value; issued and outstanding, 50,000 shares. . $1,018,485 

Total capital stock $1,018,485 

Surplus: 

Capital $ 62,393 

Earned 1,636,232 

Total surplus $1,698,625 

Total net worth $2,717,110 

Total $3,486,364 



270 



66,279 

6,611 

6,407 

$ 79,297 

$2,771,429 


-7,277 

-2,349 

-1,581 

$-11,207 

$714,935 


$ 111,032 

70,787 

139,284 


$156,714 
-70,787 
174,732 


$ 12,960 

97,392 

28,623 

$ 138,975 

$ 460,078 


$ -2,198 

49,490 

1,225 

$ 48,517 

$309,176 


$1,018,485 
$1,018,485 




$ 62,393 

1,230,473 

$1,292,866 

$2,311,351 


$405,759 
$405,759 
$405,759 


$2,771,429 


$714,935 



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272 



CASE 34 



Textron Inc. (A) 

Accounting for Federal Income Taxes 



i 



n 1961, Textron Inc., was a large multidivisional 
industrial corporation operating 90 plants with 
29,000 employees in the United States and Canada. This case is the first 
of a series describing several problems faced by Textron's management 
in the preparation of annual financial statements for distribution to stock- 
holders. This first case provides certain background information about 
the company and raises the issue of accounting for Federal income taxes, 
a problem which recurs in several subsequent cases in this series. The 
remaining cases deal with the establishment of accounting policies con- 
cerning the acquisition of new subsidiaries; the deferral of research and 
development costs; the amortization of bond discount; and the determina- 
tion and reporting of costs and liabilities for long-term lease obligations 
and for a casualty self -insurance plan. 

HISTORY OF TEXTRON INC. 

Textron was organized in 1928 and incorporated in Rhode Island 
under the name of Franklin Rayon to succeed to the business of two 
synthetic yarn dyeing and processing companies. In 1939, its name was 
changed to Atlantic Rayon Corporation, in 1944 to Textron Incorporated, 
in 1955 to Textron American, Inc., and finally in 1956 to Textron Inc. In 
this series of cases, the name Textron will be used to refer to Textron 
Inc., or the appropriate predecessor corporation. 

273 



274 Textron Inc. (A) 

Prior to World War II, Textron's annual sales volume never exceeded 
$10 million, and the Company operated at a profit in every year except 
1938 and 1940. The business expanded during the war, and in 1943 the 
Corporation began producing and selling cloth. In 1945 and 1946, Tex- 
tron acquired several large textile companies, and the sales volume in 
1946 exceeded $100 million with a profit after taxes of more than 
$7,400,000. 

Plans were made during the war for the peacetime organization of 
Textron as an integrated operation for the manufacture and sale of brand- 
named consumer products. This "vertical integration" combined under 
one management the operations of spinning, weaving, finishing, design- 
ing, sewing, and merchandising, which were usually performed by inde- 
pendent companies. Textron's bold experiment in integration proved un- 
successful, however; in 1949 the sales volume dropped to $67 million 
and, as a result of heavy inventory losses, the company sustained an 
operating loss of nearly $1,700,000. By early 1953, the company had com- 
pletely disposed of all its operations in the consumer products field and 
was concentrating on the manufacture of synthetic and cotton cloth. 

During the postwar years, the textile industry in the United States ex- 
perienced a severe readjustment, not only in the type of cloth manu- 
factured ( the switch from cotton and wool to synthetic fabrics ) , but also 
in the location of efficient manufacturing facilities (the switch from old 
multi-story plants in New England to new, one-story, windowless, air- 
conditioned plants in the South). At the end of 1947, Textron operated 
27 plants, 17 in New England and 10 in the South. In the eight years 
that followed, the company disposed of plants having a depreciated book 
value of $23,500,000, and invested $44,500,000 in new plants and produc- 
tion equipment. At the end of 1953, Textron operated only 15 plants 
located in North Carolina, South Carolina, Georgia, and Puerto Rico. 



TEXTRON S DIVERSIFICATION PROGRAM 

In mid- 1952, Textron's stockholders approved a change in the corporate 
by-laws to permit the company to engage in other types of businesses out- 
side of the textile industry. Management announced that its goal in re- 
questing this change was both to increase and to stabilize the sales vol- 
ume and earnings of the company. The textile industry was highly com- 
petitive and subject to severe cyclical fluctuations, and management hoped 
to expand the company sufficiently so that the textile business was no 
more than 50 per cent of the total enterprise. 

The company's first diversification move was made on September 30, 
1953, with the acquisition of the inventories, trade name, and business 
of the F. Burkart Manufacturing Co. of St. Louis, Missouri. The com- 



Textron Inc. (A) 275 

pany, a major producer of cotton batts and padding for the automobile, 
furniture, and mattress trades, was purchased for $1,801,052. On January 
8, 1954, all the stock of Dalmo Victor Company, a leading manufacturer 
of airborne radar antennae and related equipment, was acquired. Three 
hundred thousand dollars of the purchase price was paid in cash, 
$1,200,000 was to be paid in installments beginning in 1955 and, in order 
for Textron to retain ownership of the stock after December 31, 1963, an 
additional $1,500,000 was to be paid on or before that date. On March 25, 
1954, Textron purchased all the outstanding stock of the MB Manufac- 
turing Company, Incorporated, of New Haven, Connecticut, for $1,750,- 
000, plus an additional $250,000 to be paid to the extent that the net 
worth was not reduced by undisclosed liabilities. MB was a manufacturer 
of aircraft engine mounts and vibration testing and eliminating equip- 
ment. Textron's annual report for 1954 commented on the effectiveness 
of the diversification program up to that time by pointing out that, al- 
though total corporate profits were $1,262,000, the profits from the non- 
textile operations had been $4,298,000, an amount which exceeded the 
losses on textile operations during the year. 

In 1954, Textron began acquiring the common stock of American 
Woolen Company, the world's largest manufacturer of woolen and 
worsted fabrics, by purchases on the open market and by direct offers 
to American Woolens stockholders. Textron obtained sufficient stock to 
achieve control of American Woolen, and on February 24, 1955, Ameri- 
can Woolen was merged into Textron. Simultaneously another large tex- 
tile producer, Robbins Mills, Inc., was merged into Textron. The details 
of this merger are described more completely in the next section of this 
case, but the net result, briefly, was to double Textron's total assets and 
provide the company with sufficient excess working capital to permit an 
acceleration of the company's diversification program. Also, as a result 
of the Textron-American Woolen-Robbins merger, the surviving corpo- 
ration ( Textron ) succeeded to the net operating-loss carry-overs of these 
companies. The loss carry-overs expired within five years if not used to 
offset taxable income; therefore, the existence of this time limit exerted 
considerable pressure on Textron's management to acquire profitable 
operations in order to take advantage of the tax losses. 

The six years following the Textron-American Woolen-Robbins merger 
were a period of great activity. In 1955, Textron acquired five companies 
manufacturing electronic and precision equipment, chain saws and 
generators, metal fasteners and parts, plywood, and plastic clothesline 
and polyethylene bags. In 1956, six companies were purchased in the 
following industries: radio and television electronic parts, aluminum 
doors and windows, gray iron and alloyed iron castings, bathroom acces- 
sories, a passenger steamship, and vinyl-coated fabrics. A company pur- 
chased in 1957 manufactured valves and other fluid control equipment 



276 Textron Inc. (A) 

for aircraft and missiles. The five companies acquired in 1958 produced 
industrial hardware, machine tools, metalworking machinery, optical 
spectacle frames and optical laboratory equipment, and precision com- 
ponents for cold rolling mills. In 1959, three manufacturing companies 
were acquired in the rivet, automobile parts, and steel castings industries, 
and two service organizations were purchased, one a company doing con- 
tract research in solid state and applied physics and the other a company 
engaged in the design and engineering of industrial furnaces. Four more 
companies were purchased in 1960; manufacturers of chain saws and 
generators (in Canada), men's and boys' shoes, Fiberglas boats, and 
helicopters and rocket engines. 

About the only thing that these companies had in common was that 
they were all operating profitably under efficient management. In almost 
every case, the existing management was retained and continued to 
operate the business under Textron's ownership. Three of the companies 
purchased (the plywood manufacturer, aluminum doors and windows, 
and the steamship ) subsequently turned out to be unprofitable and were 
disposed of. 

The twenty-five businesses acquired during 1955-1960 were purchased 
in a variety of ways: sometimes cash was paid for the common stock or 
for the assets of the business; other transactions involved an exchange of 
Textron's shares for the shares or assets of the company being acquired. 
Several acquisitions provided for future purchase payments contingent 
on the future earnings of the business. During these six years, Textron 
paid or agreed to pay a total of nearly $130 million in cash and issued 
nearly 1 million shares of its common stock to the sellers of the various 
businesses. Additional payments subsequent to 1960 would also be re- 
quired for those businesses acquired under contingent payment con- 
tracts. 

The success of Textron's diversification program is readily observable 
from the series of annual operating statements and statistical data pre- 
sented in Exhibit 1. Sales volume in 1959 was more than triple the volume 
in 1954, net profit increased thirteen times, and net profits per common 
share in 1959 were seven times the results achieved in 1954. This improve- 
ment in operating results was directly attributable to the increased 
breadth of Textron's product line: prior to 1954, all sales were in the 
textile industry, but the percent of nontextile sales in subsequent years 
was 33 in 1955, 64 in 1956, 73 in 1957, 75 in 1958, and 79 in 1959. In 1959, 
no single industry accounted for more than 21 per cent of Textron's total 
volume, and the company's government business (usually less profitable 
and subject to price renegotiation) was only 13 per cent of total sales. 

In early 1961, Textron employed more than 29,000 people, most of 
them on the operating level. The various businesses were operated as 
divisions or subsidiaries and the management of each was highly de- 



Textron Inc. (A) 277 

centralized, thus placing primary responsibility for sales and profits on 
the operating managers. Less than 100 people were employed in Textron's 
corporate headquarters in Providence, Rhode Island. 



THE MERGER WITH AMERICAN WOOLEN AND ROBBINS MILLS 

Until 1954, American Woolen Company was an integrated producer of 
woolen and worsted fabrics and, until 1952, had been the largest manu- 
facturer of such fabrics in the world. During World War II, the bulk of 
American Woolen's production went to the United States Government. 
After the war, pent-up civilian demand maintained sales at high levels 
until 1951 and 1952 when the government again became the major cus- 
tomer. During these years, American Woolen did not maintain the same 
degree of research, styling, and plant modernization effort as did some 
of its competitors; in consequence, its costs of production tended to be 
relatively high, and the company's position in the civilian market dropped 
sharply. The company began incurring large operating losses in 1952, 
and in 1953, a stockholders' committee was formed to solicit proxies in an 
attempt to replace the entrenched management. Before the fight for con- 
trol was actually joined, the management of Textron became interested 
in the situation and decided to attempt to acquire control of American 
Woolen. The stockholders' committee decided that the sale of the com- 
pany to, or in combination with, Textron was the best course of action, 
and supported Textron's efforts to gain control. By a combination of open- 
market purchases and direct exchange-of-shares solicitation of American 
Woolen stockholders, Textron acquired ownership of 47 per cent of 
American Woolen common stock by the fall of 1954. 

In August 1954, Textron purchased 42 per cent of the common stock 
of Robbins Mills, Inc., from J. P. Stevens & Co., at a total price of 
$5,072,500. Robbins was engaged principally in the manufacture and sale 
of a wide variety of fabrics made from synthetic yarns and natural fibers. 
Robbins, too, had suffered declining profits in the generally depressed 
textile industry and had incurred increasing operating losses since 1952. 

The merger of American Woolen, Robbins, and Textron, proposed by 
Textron's management late in 1954, offered apparent advantages for all 
three companies (see Exhibit 2 for a tabulation of sales and operating 
results for the three companies). American Woolen owned twenty-five 
plants, of which only ten were operating in 1954. All the plants except 
three were located in New York or New England and all were old and 
relatively expensive to operate. American Woolen had also accumulated 
a substantial amount of excess working capital (the company had over 
$21 million invested in government securities at the end of October 
1954 ) as the volume of its business declined. Textron, on the other hand, 



278 Textron Inc. (A) 

had an efficient management with a proven skill in the modernization and 
relocation of textile facilities. Textron was also short of working capital 
as a result of its diversification program. Robbins' contribution to the 
combined enterprise was several modern southern plants; its need was 
for working capital. Both American Woolen and Robbins also had large 
income tax loss carry-overs, estimated in October 1954 at approximately 
$18,750,000 for American Woolen and $10,000,000 for Robbins. 

The terms of the proposed merger called for the preferred stock of 
American Woolen and Robbins to be exchanged for similar securities of 
Textron. Each common share of American Woolen was exchanged for 
two shares of Textron common, and the Robbins common was exchanged 
share for share with Textron. These terms were approved by the neces- 
sary two-thirds majority of each class of stock issued by the three com- 
panies, and the merger was consummated on February 24, 1955. 



ACCOUNTING FOR FEDERAL INCOME TAXES 

Under the provisions of the Internal Revenue Code, a company in- 
curring a "net operating loss" (as defined by the Code) in one taxable 
year may carry it back two years x for purposes of redetermining taxable 
income in those prior years and may receive a refund of all or part of 
the income taxes paid during those years. Any loss not used up by the 
carry-back may then be carried forward for five years and used to reduce 
taxable income in those future periods. 

As a result of the merger, the surviving corporation (Textron) suc- 
ceeded to the net loss carry-over which could be applied against profits 
during the first few years following the merger. At the end of October 
1954, the total operating loss carry-over of the combined companies (in- 
cluding a $1,300,000 carry-forward by Textron) amounted to $30,050,000, 
and was scheduled to expire, to the extent not utilized, as follows: 
$200,000 at the end of 1956, $14,250,000 at the end of 1957, and $15,600,- 
000 at the end of 1958. The operating losses incurred by the textile opera- 
tions of the combined companies continued to mount during 1955 and 
1956, while Textron's management was closing down unprofitable textile 
mills and starting up a new, integrated woolen mill in Barnwell, South 
Carolina. The company's 1955 annual report stated that the operating- 
loss carry-over at the end of that year was "at least $42 million." The 1956 
report stated that, "the total losses as a result of [closing old mills and 
opening the new one] since merger, charged off against other profitable 
business, exceeded $13 million." As of the end of 1956, the company re- 
ported its loss carry-forward as $45 million. Subsequent reports on the 



1 A three-year carry-back is permitted for taxable years ending after December 31, 
1957. 



Textron Inc. (A) 279 

status of the tax loss and its expiration dates are shown in Exhibit 3. 

Although not obvious from Exhibit 3, it is nevertheless a fact that 
during the years following the merger, Textron did not permit any of its 
tax loss to expire unutilized. Stated briefly, Textron was able to accom- 
plish this feat, even though reported pretax profits were insufficient to 
absorb the scheduled expirations, because certain subsidiary companies 
(which filed separate tax returns) incurred substantial operating losses 
which became available as carry-forwards for future years. The com- 
pany's annual report to stockholders reported consolidated earnings for 
both profitable and unprofitable companies as a net amount. 

An important element in managing Textron's tax-loss carry-over was 
the recognition of losses incurred in the disposal of old textile plants and 
other properties. As may be noted in Exhibit 4, approximately $31 million 
of such losses were incurred in the six years from 1954 to 1959 (total 
charges against the reserve of $32,091,998 less the $1,090,000 charge 
which was restored to paid-in surplus). Of this $31 million loss, only 
$3 million was charged against Textron's income during the six-year 
period; $7 million was charged against income by American Woolen 
prior to the merger, and $21 million was set up in the reserve account at 
the date of merger by reducing the paid-in surplus account of the com- 
bined enterprise. For purposes of income reported to shareholders, there- 
fore, these losses had a negligible impact. For income tax purposes, how- 
ever, the capital losses could only be recognized when the losses were 
actually incurred by the disposal of the properties. Thus, Textron in- 
curred new, large tax loss carry-forwards in the years following the 
merger, even though these losses had already been provided for in the 
company's regular statements. 

As a result of Textron's complex income tax problems, there were 
frequently wide variations between the company's reported profits and 
its taxable income for a given year. Exhibit 5 presents a simplified and 
summarized reconciliation between these two amounts for 1958. An 
important thing to realize about Exhibit 5 is that, although Textron's 
combined net taxable income for 1958 was $12,218,000, this amount is 
the sum of several different tax returns for the parent and subsidiary 
corporations, some of which reported large taxable income and others 
of which reported operating or capital losses. Several of the adjustments 
noted on Exhibit 5 are peculiar to Textron's situation, but many others 
(notably items 3c, 3d, 4, 5, 6, 9, and 10) would require similar adjust- 
ments by any tax-paying corporation who had transactions of this type. 

THE EFFECT OF REPORTED PROFITS ON STOCK PRICES 

Early in 1961, Textron's common stock was selling for approximately 
$22.50 per share and had ranged in price during 1960 from $18.75 to 



280 Textron Inc. (A) 

$24.75 per share. In the opinion of Textron's management, the stock was 
underpriced relative to other securities of similar investment quality. At 
$22.50, Textron was priced at only 6.2 times the 1959 earnings per share, 
whereas the typical range for most large well-established companies was 
10 to 15 times the current after-tax earnings per share. One of the pos- 
sible explanations for this apparent undervaluation of Textron stock was 
that investors were trying to anticipate the effect on Textron's earnings 
of the exhaustion of the company's tax-loss carry-forwards. If 1959's 
earnings were reduced by 52 per cent to allow for normal income taxes, 
the current stock price would be about 12.5 times the after-tax earnings. 
Textron had announced that during 1960 the company would accrue 
income taxes at a 26 per cent rate "to provide an adequate tax reserve 
against [1960's] operations in the event our existing tax-loss carry-over 
credit is used up during the year." 



Required 

1. What problems do you see in determining a set of accounting policies for 
a highly diversified business enterprise like Textron? Is it desirable to 
establish an accounting policy for, say, inventory valuation that would be 
consistently used by all divisions? Is it feasible to establish rigid accounting 
policies for such a complex of businesses? If accounting policies are estab- 
lished at the divisional level, what are the implications of preparing con- 
solidated corporate statements encompassing all the divisions? 

2. Many large corporations today report on the liability side of the balance 
sheet an amount labeled, "Deferred Federal Income Taxes." This amount 
represents the estimated tax liability on the difference between reported 
income and taxable income, and it occurs in those situations in which the 
taxpayer reports a lower taxable income (if permitted by law) than he 
reports in published financial statements. How would such a concept 
operate in Textron's situation? Should Textron report an amount on the 
asset side of its balance sheet called, "Unused Credits Against Future 
Federal Income Taxes"? How could the amount of this asset have been 
determined on February 24, 1955? How would the use of this concept 
affect the reported earnings and market price of Textron's stock? 



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281 



EXHIBIT 2 



Net Sales 
Year 
1947 
1948 
1949 
1950 
1951 
1952 
1953 
1954* 



Selected Financial Information about American 

Woolen Company, Robbins Mills, Inc., and 

Textron Inc., Years 1947-1954 

(All amounts in thousands) 



American Woolen 


Robbins 


$175,993 


$34,801 


197,849 


44,063 


132,130 


35,198 


150,124 


43,166 


253,334 


37,428 


111,866 


57,986 


73,494 


60,690 


24,498 


43,283 



Textron 


Combined 


$124,776 


$335,570 


98,847 


340,759 


67,896 


235,224 


87,547 


280,837 


98,290 


389,052 


98,745 


268,597 


70,017 


205,201 


82,049 


149,830 



Net Profit or (Loss ) 
Year 



1947 
1948 
1949 
1950 
1951 
1952 
1953 
1954* 



American Woolen 


Robbins 


$ 16,071 


$ 7,134 


16,495 


8,757 


1,030 


3,733 


5,241 


5,862 


10,240 


1,677 


(6,247) 


(774) 


(9,838) 


(2,996) 


(16,633)f 


(6,706) 



Textron 


Combined 


$ 8,317 


$ 31,522 


6,934 


32,186 


(1,663) 


3,100 


2,900 


14,003 


4,417 


16,334 


(3,543) 


(10,564) 


(195) 


(13,029) 


408 


(22,931)1 


and Textron, 


47 weeks for 



♦Partial year data: 10 months for American Woolen 
Robbins. 

fAfter provision of a reserve of $7 million for loss on disposal of closed plant 
properties. 

Sourc e: Proxy statement for the special meeting of Textron stockholders on 
February 7, 1955. 






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284 



EXHIBIT 5 



Textron Inc., and Subsidiary Companies 

Reconciliation of Reported Book Profits and Taxable 

Profits for the Year 1958 

Net profit reported in annual report. $10,756,000 

Increases or (decreases) arising from income tax adjustments : 

1. Provision for loss on disposal of steamship 2,284,000 

2. Reserve for valuation of notes receivable 1,464,000 

3. Adjustments in reserve accounts: 

Charges to Tax deduction 

1958 income allowable in 1958 

(a) Run-out expenses ... $ 121,000 $222,000 (101,000) 

(b) Losses on discontinued 

operations 1,037,000 112,000 925,000 

(c) Liability for self- 

insurance claims . . 249,000 184,000 65,000 

(d) Reserve for repairs . . 137,000 88,000 49,000 

(e) Reserve for damage 

claims 168,000 99,000 69,000 

4. Research and development costs deferred 1,334,000 

5. Amortization of research costs deferred in prior years (453,000) 

6. Contributions to the profit-sharing fund (tax deductible when paid): 

Charged to income in 1958, paid in subsequent year 595,000 

Paid in 1958 but charged against income in 1957 (702,000) 

7. Charitable contributions not allowable because of net loss on 

tax returns 103,000 

8. Income received on a damage claim recognized for tax purposes 

in 1957 but not booked until 1958 (629,000) 

9. Excess of tax deductible depreciation over book depreciation (58,000) 

10. Amortization of the excess cost of companies acquired 278,000 

11. Adjustment of accrued taxes to payment or assessment basis (487,000) 

12. Loss on redemption of stock (1,041,000) 

13. Adjustment on account of difference between book basis and 

tax basis of assets received in liquidation (1,175,000) 

14. Other adjustments (53 separate items) increasing or decreas- 

ing taxable income (1,058,000) 

Net taxable income for 1958 $12,218,000 

Source: Company records. 



285 



CASE 35 



Textron Inc. (B) 

Acquisition of a Subsidiary 



Textron began its diversification program in 1953, 
as described in Case 34, and the pressure to 
purchase profitable subsidiaries was intensified by the large tax-loss 
carry-forwards acquired by the company's merger in early 1955 with 
American Woolen Company and Robbins Mills, Inc. One of the first 
companies purchased by Textron following the merger was Supreme 
Cameras, Inc., 1 a well-known manufacturer of high-quality cameras and 
other photographic equipment. 

HISTORY OF SUPREME CAMERAS, INC. 

Supreme Cameras had been founded in 1924 by two brothers, Irving 
and William Shaw, to manufacture high-quality still cameras for press 
and portrait photographers. The market for professional cameras was a 
limited one, and the company grew slowly until 1940. Government con- 
tracts during World War II caused a large increase in Supr erne's sales 
volume, and after the war the owners decided to expand their business 
by entering the amateur photography field. Supreme's reputation for 
professional quality cameras was a major asset in entering the consumer 
market, and the years following 1950 saw a rapid increase in sales. 



1 The name, industry, and certain other historical information concerning the sub- 
sidiary have been changed to avoid disclosure of confidential information. 

286 



Textron Inc. (B) 287 

Volume, which prior to 1940 had never exceeded $500,000, rose to over 
$6 million in 1950 when Supreme introduced its first 8 millimeter home 
movie camera. Sales in 1951 exceeded $12 million and rose to $15.6 million 
in 1952 and to $17.7 million in 1953. An income statement for 1954, in- 
dicating a sales volume of $19.7, is shown in Exhibit 1. 

The spectacular success of Supreme Cameras, Inc., was not an un- 
mixed blessing for the Shaw brothers, who still owned approximately 
one-third of the common stock in 1955. These men, then in their late 
fifties, were concerned about the estate tax problems their beneficiaries 
would face in valuing their stock in the event of their death and in rais- 
ing the money to pay the tax levied on their estates. The owners were 
also burdened with very heavy current income taxes. Profits during 1952- 
1954 had risen at a rate which outstripped the company's ability to ab- 
sorb the funds thus generated and, as a result, large dividends had been 
paid during those years. In addition, each of the brothers drew a sub- 
stantial salary as an executive of the company. In 1954, the owners' legal 
counsel advised them to consider selling the business in order to diversify 
their own investment and to permit the realization of a substantial profit 
that would be taxed as a capital gain rather than as ordinary income. 



NEGOTIATING A PURCHASE PRICE 

Informed by an investment banker of Supreme's willingness to sell, 
Textron's management decided to buy the company if a mutually satis- 
factory purchase price could be agreed upon. The book value of Supreme's 
stock was obviously far less than its market value; as of April 30, 1955, 
when the sale was finally consummated, the book value was only $2,349,- 
000, scarcely one and one-half times the after-tax earnings of the com- 
pany ( see Exhibit 2 ) . The Shaw brothers also pointed out that the book 
value of the stock was drastically understated because of certain account- 
ing policies used by Supreme. For example, inventories were valued 
under a LIFO system; if valued at the lower of cost or market on a FIFO 
basis, the inventories on April 30, 1955, were worth approximately 
$6,142,000. Furthermore, a great deal of the company's plant and equip- 
ment had been acquired in recent years under emergency certificates is- 
sued by the government; these certificates permitted the company to 
amortize a substantial portion of the cost of the facilities over five years. 

After a considerable period of negotiation, Textron agreed to purchase 
all Supreme's common stock for $5 million cash ( paid on April 30, 1955 ) 
plus a series of contingent payments to be made over the succeeding ten 
years. These payments, which were construed as part of the purchase 
price of the company, were to be equal to 25 per cent of the pretax earn- 
ings (as defined in the agreement) of the company in each of the next 



288 Textron Inc. (B) 

ten years, but not to exceed 100 per cent of the after-tax earnings. These 
unusual purchase terms offered important advantages to both buyer and 
seller. Both parties agreed that the purchase price should reflect the 
expected future earnings of Supreme, but it was very difficult to agree 
on what the magnitude of those earnings would be. Using the con- 
tingent payment device, Supreme's owners would expect to receive sub- 
stantial future payments (taxable as a capital gain), and Textron would 
be permitted to pay a major portion of the purchase price directly from 
the earnings of the newly acquired subsidiary. 



THE NEED FOR A NEW ACCOUNTING POLICY 

Textron's acquisition of Supreme Cameras, Inc., was different from any 
previous transaction the company had experienced, although Textron's 
management anticipated that the contingent payment method might be 
used in subsequent acquisitions. Textron's controller, therefore, had to 
develop a new accounting policy for recording such acquisitions on a 
consistent basis. 

For income tax purposes, the Supreme acquisition was relatively 
straightforward. The Internal Revenue Code did not permit the amortiza- 
tion of goodwill to be deducted as an expense in the determination of 
taxable income. Therefore, it was desirable for the taxpayer to attribute 
as much of the purchase price as possible to tangible assets which could 
ultimately be charged off as tax-deductible expenses. For income tax 
purposes, Textron decided to record Supreme's inventory at the lower 
of FIFO cost or market (rather than at LIFO cost) and to record the 
fixed assets at their appraised fair market value as of April 30, 1955, the 
date of purchase. The fixed asset appraisal, done by the American Ap- 
praisal Company, indicated that the fair market value of the fixed assets 
was $3,722,000. 

As noted in Case 34, Textron had many differences between its pub- 
lished financial statements and its income tax returns. Therefore, the tax 
treatment of the Supreme acquisition was in no way binding upon the 
treatment to be used for published financial reports. 

Required 

1. How should the acquisition of Supreme Cameras, Inc., be handled in 
Textron's corporate accounts? Should inventories be recorded at LIFO or at 
current cost? Should the fixed assets be recorded at book or appraisal 
values? What entry would you make to record the $5 million disbursement 
on April 30, 1955? 

2. How does the existence of the contingent future payments affect the treat- 
ment of this acquisition? What entry would you make in future years assum- 



Textron Inc. (B) 289 

ing that the Supreme Camera Division had pretax earnings of, say, 
$3,200,000 and that Textron paid $800,000 each year to Supreme's 
founders? 
3. Draft a statement of the accounting policy which you believe Textron 
should follow in recording the acquisition of subsidiaries under contingent 
payment purchase agreements. 






EXHIBIT 1 



Supreme Cameras, Inc. 

Statement of Profit and Loss for the Year Ended 

December 31, 1954 

(In thousands) 

Net sales $19,732 

Cost of goods sold 13,341 

Gross profit $ 6,391 

Operating expenses 3,013 

Operating profit $ 3,378 

Interest and other deductions (net) 264 

Net income before taxes $ 3,114 

Estimated Federal income tax 1,600 

Net income after taxes $ 1,514 

Supreme Cameras, Inc. 

Balance Sheet on April 30, 1955 

(In thousands) 



EXHIBIT 2 



Assets 



Current assets 



Cash $1,759 

Receivables (net of reserve) 2,729 

Prepaid expenses 49 

Inventories (LIFO) 3,765 



Total current assets 



Fixed assets 



,302 



50 

618 



Land 

Buildings and machinery $2,481 

Less depreciation 1,863 

Leasehold improvements $ 98 

Less amortization 7 91 

Total fixed assets $ 759 

Other assets $ 35 

Total assets $9,096 

Liabilities and Capital 

Current liabilities 

Accounts payable $ 655 

Current portion of long-term debt 305 

Accrued expenses 1,174 

Provision for Federal income taxes 1,750 

Total current liabilities $3,884 

Long-term debt 

Notes payable after one year 2,863 

Total liabilities $6,747 

Capital stock and surplus 

Common stock-$10 par $ 300 

Earned surplus 2,049 

Total equity 2 »349 

Total liabilities and equity $9,096 



290 



CASE 36 



The 

Reece Corporation 



D 



uring 1953, the American Accounting Associa- 
tion, under a grant from the Merrill Founda- 
tion for the Advancement of Financial Knowledge, undertook a research 
project on the effects of inflation on capitalistic enterprise. As a part 
of its research project, the Association planned a series of four case 
studies of American corporations. 

One of the companies offering to cooperate in the study was The 
Reece Corporation of Waltham, Massachusetts. Mr. Franklin Reece, the 
president, had long been concerned with the possible misunderstanding 
and danger arising during a period of inflation in which no planned 
account is given in published statements of the changes taking place in 
the purchasing power of the dollar. 

In the case study, The Reece Corporation was discussed as follows: 

The Reece Button Hole Machine Company was founded and incorpo- 
rated in 1881 under the laws of the state of Maine for the purpose of 
producing and marketing John Reece's invention, the first machine auto- 
matically to stitch eyelet-end buttonholes in the high button shoes of that 
day. In the following year, a second Maine corporation, The International 
Button Hole Sewing Machine Company, was separately capitalized and 
became the exclusive marketing agent for Reece products in foreign 
countries. 

From its inception, the Company has specialized in automatic sewing 

291 



292 The Reece Corporation 

machines for such short cycle stitching operations as button sewing, tack- 
ing, short-seam overedging, and eyelet stitching in addition to the many 
varied kinds of buttonhole sewing required by the shoe and garment 
industries. The Company, it is believed, was among the first to lease 
exclusively rather than sell its products. This policy was followed until 
1930 when an irrevocable ninety-day option to purchase or lease was 
granted to customers upon the installation of new equipment. 

In 1948, the two original companies merged to form a new Massachu- 
setts corporation, The Reece Corporation. In 1949, its manufacturing de- 
partments were moved from Boston to Waltham, and in 1954 the admin- 
istrative, sales, and engineering departments also were moved there. The 
Company maintains branch offices for sales and service in twenty major 
garment producing centers in the United States. Five subsidiary com- 
panies and twenty-eight agents in thirty-three foreign countries sell, lease, 
and service its products abroad. 1 

As a result of the study conducted by the American Accounting Asso- 
ciation with The Reece Corporation, The Reece Corporation began in- 
cluding information in its annual report on the price level problem. In its 
seventy-fourth annual report for the year ended December 31, 1955, The 
Reece Corporation included the data shown in Exhibit 1. 



Required 

1. Do you think this step by The Reece Corporation is a desirable one for it 
to take? Should other corporations do the same? 

2. What other steps, if any, should corporations take to bring the price level 
problem to the attention of their stockholders and the public? 

3. Do you anticipate Mr. Brooks, the treasurer, will get much response from 
his request? What type of response do you think it will be? 



1 Ralph C. Jones, Case Studies of Four Companies (Columbus, Ohio: American 
Accounting Association, 1955), p. 110. 



EXHIBIT 1 



Excerpt from the Annual Report for Year Ended 
December 31, 1955 



The purpose of the Price Level Study is to compare the Company's financial 
statements as prepared by conventional accounting with these same statements 
after adjustment to show the effect of inflation. 

In applying the Price Level Study to the Company's figures, we compare His- 
torical Dollars— those with which we are all sadly familiar and which have lost 
more than half their purchasing power in the last fifteen years— with Uniform 
Dollars. The Uniform Dollar used is defined as a uniform measuring unit whose 
purchasing power is equal to the 1955 dollar. In order to prepare the accompany- 
ing charts, the Company's financial statements from 1940 to date have been re- 
stated in 1955 Uniform Dollars by means of index numbers based on the Consum- 
ers Price Index. For chart purposes, both Historical Dollar and Uniform Dollar 
amounts have been expressed as a percentage of 1940 in order to establish a 
common point of departure. 

From the first chart, it is apparent that, in Historical Dollars, Gross Income 
was almost four times as large in 1955 as it was in 1940, whereas in Uniform 
Dollars it is only about twice as large. 1955 net income after taxes in Historical 
Dollars is 2.9 times as great as that for 1940, yet in Uniform Dollars it is only 
1.4 times as large. 



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293 



EXHIBIT 1, cont'd 



Fortunately, the Price Level, or cost of living, has increased only slightly in 
the last four years; therefore conventional accounting methods, which entail the 
use of Historical Dollars, do not seriously distort the income statement for 1955. 
Nevertheless, in converting 1955 figures to Uniform Dollars, we find that depre- 
ciation, charged without regard for actual replacement cost, is understated by 
$49,000 and taxable income overstated by $44,000, the difference representing an 
adjustment to cost of sales. It follows that the Federal Income Tax applicable to 
these fictitious earnings is a tax on capital. 

Studying a Company's financial statements when expressed in Uniform Dollars 
has a sobering effect in these days of high production, apparently high profits, 
and general prosperity. The true growth of a company becomes apparent, the 
false basis of taxable income is highlighted and, in the case of this Company, one 
finds that earnings plowed back in the business are only about fifty- eight per cent 
as large as indicated by conventional accounting practice. 

The rising cost of machinery and buildings over the last fifteen years is one 
of the most serious problems that face manufacturing companies. These costs 
have gone up significantly faster than is indicated by the Consumers Price Index 
which has been used in preparing this Price Level Study. Unfortunately, we do not 
know of a Price Index that could properly be applied to a manufacturing concern 
so we have used the Consumers Price Index, but we recognize that it falls short 
of indicating the full effect of inflation on this Company. The Price Level Study' 
indicates that the Company's reserves for depreciation are 25% or $703,000 less 
than they should be. No doubt the true inadequacy of the reserves is nearer 40%, 
or more than $1,000,000. As equipment wears out or becomes obsolete, it must 
be replaced. Since depreciation reserves are inadequate to provide for replace- 
ment, retained earnings or borrowed money must be used to help pay for the re- 
placement equipment. 

We believe that the comparison of financial results in Historical Dollars with 
those converted to Uniform Dollars is an invaluable management tool. However, 
the theory and application of the Price Level Study is difficult to understand even 
after considerable study. Therefore, we wonder if it is of interest to readers of 
this report. Would you please note on your proxy whether or not you think we 
should include this section in future reports. 

W. D. Brooks, Jr., Treasurer 



294 



DEFERRED EXPENSES 



CASE 37 



Textron Inc. (C) 

Research and Development Costs 



Textron had succeeded to large operating loss carry- 
forwards as a result of its merger in 1955 with 
American Woolen Company and Robbins Mills, Inc., as described in 
Case 34. As of the end of 1956, Textron's annual report stated that the 
total loss carry-over then amounted to $45 million, of which $14 million 
was scheduled to expire at the end of 1957 if not utilized. Thus, contrary 
to the problem faced by most corporate tax departments, Textron's tax 
department was trying to find allowable tax treatments which would 
increase the company's current taxable income, thereby using up the 
expiring portion of the tax-loss carry-forwards. The tax department 
realized that there was a value in preventing the expiration of some 
unused tax loss only if the taxable income generated in 1957 resulted in 
the creation of tax-deductible items in subsequent years. 

Textron's diversification program, begun in 1953 and accelerated in 
1955, was proceeding satisfactorily in 1957. Consolidated net income for 
1956 amounted to $6,503,000 in total, but the chairman's annual letter 
to stockholders pointed out that this was the net result of profits of 
$12,315,000 in the nontextile divisions, offset by losses (partially non- 
recurring) of $5,812,000 on textile operations. An increase in profits was 
expected in 1957, but there was some doubt that taxable profits would 
be sufficient to absorb the loss carry-forward expiring in that year. 

295 



296 Textron Inc. (C) 

After consultation with its legal counsel, Textron's management de- 
cided that the company should elect to change its method of deducting 
research and development costs for tax purposes. The Internal Revenue 
Code permitted a taxpayer to treat research or experimental expenditures 
as currently deductible expenses, and this treatment was the one most 
commonly used by most businesses. The Code also permitted a taxpayer 
to elect to treat such expenditures as deferred expenses, amortizable 
ratably over a period of not less than sixty months, beginning with the 
month in which the taxpayer first began to realize benefits from the 
expenses. Textron's decision was to use this latter treatment for iden- 
tifiable research projects in certain operating divisions. Information re- 
garding these expenses during 1956 and 1957 was collected from the 
division managers, and the revised tax treatment was elected as of Jan- 
uary 1, 1956, by filing an amended tax return for 1956. 

In its 1957 income tax return, Textron reported that $1,491,000 of 
research expenditures for the year had been deferred. The company 
deducted $136,000 of amortization in 1957 for projects deferred in 1956 
and 1957 which had begun to produce benefits during 1957. In addition, 
$34,000 was deducted in 1957 as expenditures previously deferred on 
projects that had since been abandoned as fruitless. In 1958, Textron's 
tax return indicated deferrals of $1,334,000 and deductions for amortiza- 
tion and abandonments of $453,000. 

One of the divisions participating in this tax deferral of research ex- 
penditures was the Supreme Cameras Division, 1 acquired by Textron 
in 1955 as described in Case 35. In order to broaden its product line and 
thus permit a continuing expansion of sales volume and profits, Supreme 
had greatly increased its expenditures for research and development 
since its acquisition by Textron. In the report requested by Textron's tax 
department for 1957, Supreme's management had listed nearly fifty spe- 
cific research or development projects that had occasioned some ex- 
penditure during the year. The total amount spent on these projects in 
1957 amounted to $435,000. A list of some of the more important projects 
and the amounts spent on them in 1957 and 1958 is presented in Exhibit 1. 

Supreme's research expenditures in 1958 nearly doubled the 1957 out- 
lay, due primarily to heavy costs in the development of a radically new 
8-millimeter sound movie camera and projector. Supreme hoped to be 
the first producer in the industry to offer this type of equipment at a 
price low enough to attract the amateur market. The product was sched- 
uled for introduction early in 1961 and, on the recommendation of 
Supreme's management, Textron's board of directors had approved the 
expenditure of up to $1 million during 1958-1960 for the necessary re- 
search and development. 



1 Disguised name. 



Textron Inc. (C) 297 

At the time that Textron elected to defer research expenditures on 
certain projects for tax purposes, management also considered adopting 
a similar treatment of those expenses in its corporate financial reports. 
The deferral of these expenses was permissible under "generally accepted 
accounting principles," but the auditor's opinion on the financial state- 
ments in the year of the change in procedure would have contained an 
"exception," because the statements would not have been prepared "on 
a basis consistent with that of the preceding year." 

Textron decided not to adopt the deferral treatment in its regular books 
because, as the controller pointed out, "Deferring research expenditures 
is not regarded as conservative accounting practice. There are several 
obvious disadvantages in the treatment: the balance sheet reflects an 
intangible asset of dubious value, the amortization period must neces- 
sarily be arbitrary, and there is no guarantee that the business will, in 
fact, receive any future benefits from past research expenditures. Even 
more important, however, is the effect that such a change might have 
on the attitude of readers of our financial reports. We follow relatively 
conservative accounting practices, and we think our stockholders have a 
great deal of confidence in the profit figures and other data we publish 
periodically. A single, relatively minor change such as deferring part of 
our research expenses might do far more damage to investor confidence 
in our statements than would be justified by the theoretical improvement 
in the accuracy or validity of our reported profits/' 



Required 

1. Do you think that all or any part of the research expenditures for the 
Supreme Cameras Division should have been deferred in Textron's regular 
accounts in 1957? What is the advantage to shareholders of the conservatism 
advocated by Textron's controller in the preparation of published state- 
ments? Is the doctrine of conservatism compatible with the accounting 
principle of matching costs and revenues in the determination of net in- 
come? How does the doctrine of consistency in the application of an ac- 
acounting policy affect the determination of income in this case? 

2. Because Textron decided not to defer research expenditures for book pur- 
poses but did defer them for tax purposes, there would be a difference be- 
tween profits reported on the income statement and taxable profits in 1957 
and later years. Compare this situation to the more common one for many 
companies in which tax deductions may precede book deductions and thus 
lead to the creation of a "Deferred Federal Income Taxes" liability on the 
balance sheet. Should Textron establish an asset account entitled "Prepaid 
Federal Income Taxes"? How would this asset differ, if at all, from the asset 
account discussed in Case 34 entitled "Unused Credits Against Future 
Federal Income Taxes"? Work out a simple example illustrating the use of 
one or both of these accounts, as you think appropriate. 



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298 



CASE 38 



Textron Inc. (D) 

Determination and Amortization of Bond Discount 



o 



n May 12, 1959, Textron Inc., issued $30 million 
of 5 per cent subordinated debentures, due May 
1, 1984. Attached to each debenture were "warrants" entitling the pur- 
chaser to buy Textron common stock at stated prices during the next 
twenty-five years. The purpose of the issue was to provide funds for 
retiring one of the company's outstanding issues of preferred stock, for 
reducing short-term indebtedness, and for other general corporate pur- 
poses, including the continuance of the company's diversification pro- 
gram. The bonds were priced to the public at par, but underwriter's 
discounts and commissions amounted to 4 per cent and reduced Textron's 
share of the proceeds to $28,800,000. In addition, Textron incurred cer- 
tain financing expenses totaling $82,754.09 and paid federal stamp taxes 
on the debentures amounting to $33,000. Textron's net cash proceeds 
on the issue were therefore $28,684,245.91. 

Each debenture as initially issued had two warrants attached, entitling 
the debenture holder to purchase for cash a total of twenty shares of 
Textron common stock for each $1,000 principal amount of the deben- 
tures. The purchase price for the common stock upon exercise of the 
warrants was $25 per share during the period ending May 1, 1964; $30 
per share for the period ending May 1, 1969; $35 per share for the period 
ending May 1, 1974; $40 per share for the period ending May 1, 1979; 
and $45 per share for the period ending May 1, 1984, when the warrants 
would expire. The closing price of Textron common stock on May 1, 

299 



300 Textron Inc. (D) 

1959, on the New York Stock Exchange, was 24% ($24,125). One 
warrant on each debenture, for one-half of the shares, was detachable 
immediately and could be exercised at any time after June 1, 1959. The 
other warrant, for the remaining ten shares, was detachable and exer- 
cisable after May 1, 1960. 

Under the terms of the debentures, a sinking fund was established to 
provide for the retirement of the debentures. Textron agreed to pay 
into the fund the net proceeds that it might receive upon the sale of 
common stock through exercise of the warrants, less the cost to Textron 
of debentures acquired by it and retired. In addition, Textron agreed 
to pay into the fund $400,000 annually, in quarterly installments begin- 
ning August 15, 1964. Monies thus paid into the sinking fund would 
be used by the trustee to purchase and retire outstanding debentures, 
such purchases to be made at the lowest prices offered by debenture 
holders, but not to exceed the principal amount plus accrued interest. 
Textron had the option of redeeming the debenture issue, in whole or 
in part, upon thirty days' notice, at a redemption price equal to their 
principal amount plus accrued interest thereon up to the date of re- 
demption. 

The debenture issue was well received in the bond market and, as is 
customarily the practice on issues involving a package of more than one 
type of security, some of the first purchasers of the combined debenture- 
warrant package immediately began offering to sell their warrants sep- 
arately from their debentures. Market prices were thus established for 
three separate securities: the debentures without any warrants attached, 
priced at $730 per $1,000 debenture on May 12, 1959; the warrants 
exercisable after June 1, 1959, priced at $133.75 per 10-share warrant 
on May 12, 1959; and the warrants exercisable beginning on May 1, 

1960, priced at $127.50 per ten-share warrant. 



Required 

1. Why did the warrants to buy Textron common stock at prices higher than 
the then current market price have any value of their own on May 12, 
1959? Does the fact that the warrants apparently had a value mean that the 
debentures, therefore, were sold at a discount? If so, what was the amount 
of the discount? 

2. Over how long a period should the bond discount (if any) be amortized? 
What entry would you make concerning unamortized bond discount as- 
suming that on May 1, 1961, Textron's sinking fund purchased debentures 
with a face value of $125,000 for $99,800 and retired them? 

3. Assume that on May 1, 1962, Textron's common stock was selling for $32 
per share and warrants for 6,000 shares were exercised yielding proceeds to 
Textron of $150,000. Textron would have to use these proceeds to retire 
debentures which could be purchased on the market, at, say, $775 per $1,000 






Textron Inc. (D) 301 

per debenture. What entry would you make to record this entire transac- 
tion (sale of stock, retirement of debentures, and write-off of unamortized 
discount)? Should the discount at which the common stock is sold at this 
date ($7 per share) be considered in recording this transaction? 



CASE 39 



Trans World 
Airlines 



i 



n February 1959, Mr. John Smith, 1 controller of 
Trans World Airlines, was reviewing the company's 
policy concerning the amortization of acquisition and integration ex- 
penses incurred in the introduction of new aircraft into revenue service. 
TWA had placed its first jet, a Boeing 707, in service the previous month, 
and was expecting further rapid additions to its jet fleet. By the end of 
1960, it was planned that the airline's jet acquisition program would be 
completed and that at least forty-five jets would be flying the TWA em- 
blem. More might be added if the demand for TWA jet service proved 
adequate. 

The jet acquisition program for TWA had been initiated in 1955. Its 
first orders were placed early in the following year. In the intervening 
period until 1959, a considerable amount of corporate time and energy 
had been expended in preparing for the introduction of the jet planes. 
The planning and technical staffs had been involved in the program right 
from the start, in consultations with the manufacturers and in the many 
other preparations that were necessary within TWA. Now that the jets 
were coming into service, there would have to be intensive advertising, 
a considerable amount of training, and numerous other expensive activ- 
ities, all connected with the integration of the jet planes. The nature 



1 Names of all persons in this case are fictitious. 

302 



Trans World Airlines 303 

and details of these expenses will be discussed in more detail below. 
Briefly, however, TWA expected to have spent nearly $17 million on 
acquisition and integration before the jet fleet was completely integrated. 



COMPANY BACKGROUND 

TWA was a long-established and progressive airline, with an excellent 
reputation. It ranked as one of the major domestic carriers, with routes 
on the Eastern seaboard, in the Midwest and on the West Coast. It also 
served several important transcontinental routes, including Miami-San 
Francisco and New York-Los Angeles. In addition, TWA ranked second 
only to Pan American Airways as a United States flag carrier in inter- 
national operations. It provided extensive overseas service to Western 
Europe, the Middle East, and Southeast Asia. (Balance sheets for 1957 
and 1958 are shown in Exhibit 1; financial and other operating results 
for the period of 1950 through 1958 are summarized in Exhibit 2, together 
with an estimate of 1959 results.) 

In 1955 TWA (and all other major airlines) had begun planning the 
acquisition of jet aircraft. Its final decision was to order a total of thirty- 
three Boeing 707's and thirty Convair 880's. Delivery of the planes was 
expected mainly in 1959 and 1960. 

The total commitment involved in these orders was upward of $300 
million, including necessary spare parts. In the interim, however, further 
expenditures in the amount of $90 million were made in the acquisition 
in 1957 of Lockheed Super Constellations and other aircraft, to fill out 
the TWA fleet until time of delivery of the jets. TWA financed a major 
part of the acquisition of the Lockheed aircraft through bank loans and 
a stock issue in 1957. 

As matters stood early in 1959, TWA's first jets were being delivered 
by Boeing to TWA's holding company, the Hughes Tool Company, which 
in turn leased the planes to TWA on a short-term basis. This arrange- 
ment was quite separate from the decision that the company would be 
making on the question of the long-term financing that would be needed 
in due course to cover the full fleets. It was apparent from the company's 
1958 annual report that arrangements had not yet been completed in 
this regard. 

Among the many proposals that were being discussed at this time was 
a generally accepted proposition that, sooner or later, TWA would ac- 
quire the jet planes in its own right. This in turn would mean large- 
scale expansion of TWA's capital structure. It was fairly obvious that 
major outside financing was going to have to be arranged as part of this 
plan. TWA's financial men were conscious of the fact that the airline's 
ability to accomplish this might well be impaired by its recent profit 



304 Trans World Airlines 

history (refer to Exhibit 2). It was true that a strong improvement was 
expected in 1959, but investors on the scale that TWA required were 
expected to be hesitant to commit a large amount in a company whose 
prospects might seem uncertain in the light of the immediately previous 
years' experience. It was therefore extremely important that any improve- 
ment in the profit situation manifested in 1959 be not only substantial 
and impressive, but also strong enough to carry through to subsequent 
years. 

It was against the background of these circumstances that Mr. Smith 
was conducting his policy review. 



PREVIOUS POLICY 

Mr. Smith recalled that previous to 1956 it had not been felt necessary 
to have any specific policy on the amortization of this type of deferrable 
expense. Expenses of this nature had run at such a low level that they 
had simply been treated as part of the cost of doing business in the year 
in which they had been incurred. 

In 1956, however, a significant change had taken place. TWA had 
started a fairly considerable program of acquisition and integration ex- 
pense in connection with its new Lockheed planes. Approximately $4 
million was to be spent under these headings. Under the circumstances, 
it was felt that deferral was required under a Civil Aeronautics Board 
regulation. 2 It was decided to amortize these expenses on a straight-line 
basis over a five-year period, beginning at the estimated mid-point of 
the period during which the new planes were being integrated into reve- 
nue service. 

It was important to note, however, that such expenses were still 
claimed and allowed as current expenses for income tax purposes, despite 
the fact that they were not included as expenses in the published income 
statement. This meant that the income taxes apparently payable on re- 
ported profits exceeded the amount payable on profits determined for 
income tax purposes, the excess being equivalent to the corporate tax 
rate of 52 per cent multiplied by the amount deferred. In the published 
financial statements, this "excess" income tax was included in the taxes 
shown as payable on reported income, and set up in a special liability 
account described as "Deferred Federal Income Taxes." This deferred 



2 Paragraph 241.2-4(c) of the "Uniform System of Accounts and Reports for Air 
Carriers," as published in the Federal Register of June 23, 1956, stated as follows: 
"Expenditures incurred during the current accounting year which demonstrably 
benefit operations to be performed during subsequent accounting years to a significant 
extent shall be deferred and amortized to the period in which the related operations 
are performed when of sufficient magnitude to distort the accounting results of the 
year in which incurred." 



Trans World Airlines 305 

liability would be transferred to the current liability heading "Accrued 
Income Taxes" in future years when amortization was recorded on the 
books but disallowed for tax purposes (disallowed since the full amount 
would have been allowed in a previous year). The net result would be 
that each year's income statement would show the income taxes ap- 
parently payable on reported profits, but the liability shown for current 
payments would be the amount actually payable after the special re- 
computation of income for tax purposes. The deferred tax account would, 
of course, show a zero balance at the end of the amortization period 
chosen by TWA. 



CURRENT PROBLEM 

Exhibits 3 and 4 give some detailed information on the expenses under 
consideration. They had been prepared by Mr. Smith on the basis of 
actual accruals to date, plus budgeted estimates of future trends. 

Exhibit 3, "Acquisition Expenses," shows the main expense headings 
for all the activities concomitant with the actual purchase of the jets, 
"purchase" being used in the sense of the whole process involved from 
the time that acquisition first came under consideration until the planes 
were delivered. 

Exhibit 4, "Integration Expense," includes all activities from receipt of 
the planes until the time that they were placed in revenue service. For 
example, a considerable sum of money was spent on introductory ad- 
vertising, acquainting the public with the availability, comfort, and the 
advantages of jet flights. Some of the other important categories included 
in integration activities would be training of personnel (ground and air 
staff), publicity and proving flights, maintenance and other operating 
expenses during the integration period, and direct administrative expenses 
while all this was taking place. 

Up to the end of 1958, TWA had simply gone ahead on the presump- 
tion that the same policy would be followed with regard to the jets as 
had been developed when the new Lockheed planes were introduced. 
The fact that total deferrals up to that time were a very minor part of 
the anticipated total was very probably the reason why no serious atten- 
tion was paid to the matter before 1959. When Mr. Smith began to study 
the question in 1959, however, he did so with the full expectation that 
1959 and 1960 would see tremendous expenditures under the headings 
in question. 

Mr. Smith's first impulse (to use the same amortization basis as had 
been used on the Lockheed integration expenses ) was checked when he 
learned from a high official in another major airline that it had chosen 
a seven-year basis. Furthermore, there was talk that another airline had 



306 Trans World Airlines 

chosen a ten-year period. Mr. Smith started wondering just what basis 
TWA should use to amortize the deferred expenses. Should they be de- 
ferred at all? Since jet service was coming in quite fast in 1959, he felt 
that he could probably argue that the expenditures made in that year 
were "current" operating expenses, even though they did also benefit 
future periods. 

Another question that came into Mr. Smith's mind was whether he 
might choose different treatments for different classes of expenses in- 
cluded under the main headings. For example, he wanted to anticipate 
the problems that might arise if TWA were to assume ownership of all 
or some of the planes during the integration period. In that event, there 
would be no rentals paid, but TWA would bear interest and deprecia- 
tion expense. In the opinion of his assistant, Mr. Jones, depreciation was 
something that was quite clearly "gone," and Mr. Jones didn't like the 
idea of deferring any of it. 

Mr. Smith noted the following facts that might help him in his deci- 
sion. First, the "mid-point" of the integration period of the jet fleet could 
probably be said to be around December 1959-January 1960. Second, 
the lives used in calculating depreciation on the planes would probably 
be ten years for the airframes and five years for some engines and seven 
years for others. TWA would use depreciation bases comparable to those 
used by other air carriers, if and when it took over the planes from the 
holding company. 



Required 

1. Answer the questions which Mr. Smith posed toward the end of the case: 
What basis should TWA use to amortize the deferred expenses? Should 
they be deferred at all? Should any differentiation be made between differ- 
ent classes of expenses? 

2. Show the deferred income tax account in TWA's books relative to the jet 
acquisition and integration program, under the amortization base you have 
selected. Start with the year ended December 31, 1956, and continue until 
the account is reduced to a nil balance. You may assume an income tax 
rate of 50 per cent. 



EXHIBIT 1 



Consolidated Balance Sheets at December 31, 

1957 and 1958* 

($000,000) 



1958 1957 



Current assets: 

Cash & U.S. Govt, securities $ 41.2 $ 30.0 

Accounts receivable 23.9 24.0 

Inventory of spare parts, etc 12.5 13.8 

Prepayments 2.6 2.3 

Total current assets $ 80.2 $ 70.1 

Noncurrent assets and investments $ 3.0 $ 1.9 

Property and equipment-at cost $339.0 $324.0 

—less depreciation 177.8 151.9 

-net $161.2 $172.1 

Deferred debits: 

Long-term prepayments $ 1.7 $ 1.7 

Costs deferred re new overhaul base 2.0 2.7 

Costs deferred re aircraft acquisition and integration! . . 4.7 4.2 

Miscellaneous 1.5 0.9 

Total deferred debits $ 9.9 $ 9.5 

Total $254.3 $253.6 

Current liabilities: 

Short-term notes payable to banks - $ 12.0 

Current maturities of long-term debt $ 14.2 12.2 

Accounts payable, deposits, & accruals 44.6 34.4 

Accrued income taxes 0.2 0.5 

Unearned revenue 5.7 5.8 

Total current liabilities $ 64.7 $ 64.9 

Long-term debtf $ 67.1 $ 63.2 

Deferred Federal income taxes $ 12.3 $ 13.6 

Stockholders' equity: 

Capital stock, $5 par $ 33.4 $ 33.4 

Paid-in surplus 48.9 48.9 

Retained earnings s 27.9 29.6 

Total stockholders' equity . $110.2 $111.9 

Total $254.3 $253.6 



♦Summarized from published financial statements, 
t Including nonjet fleets. 

^Includes notes payable to Hughes Tool Company, $18.1 million in 1958 and 
$5.8 million in 1957. 

SDebt agreements prohibited payment of cash dividends in both years. 



307 



EXHIBIT 2 



Operating Results, 1950-1958*, and 
Estimate for 1959 

1959 1958 1957 1956 1955 1954 1953 1952 1951 1950 
(est. ) 

($ millions) 

Passenger revenue . . $300 248 231 210 189 174 160 135 114 88 

Other revenue . . 



Total Operating 
Revenue . . 



50 


37 


33 


30 


28 


30 


27 


26 


28 


29 


$350 


285 


264 


240 


217 


204 


187 


161 


142 


117 



Wages & Salaries . . . $125 115 110 101 85 77 74 63 53 45 

Depreciation, amor- 
tization, obsoles- 
cence! 35 32 27 20 20 22 23 17 12 11 

Other expenses 170 139 132 123 100 82 79 66 61 50 

Total Operating 

Expenses $330 286 269 244 205 181 176 146 126 106 

Operating income ... $ 20 12 23 11 15 16 11 

(Loss) $1 5 4 

Income taxes $ 11 1 (3) (2) 7 13 6 7 8 3 

Net Income (Loss) . . . $ 9 (2) (2) (2) 5 10 5 8 8 8 

(thousands) 

Revenue passengers . . 5,500 4,723 4,818 4,428 4,048 3,594 3,140 2,573 2,223 1,706 

(millions) 

Seat miles flown .... 8,000 7,256 6,985 6,202 5,405 4,768 4,110 3,155 2,577 2,264 

Revenue ton miles .. . 650 514 492 452 405 373 336 274 234 186 



Payload factor 62.5 57.8 57.2 60.7 61.8 64.2 65.7 67.8 66.8 61.2 

^Summarized from 1958 Annual Report. 

tExcluding write-offs discussed in this case, except to the nominal extent that current 
policy allowed for such write-offs (dating from and including 1956). 



308 



EXHIBIT 3 



Jet Aircraft Acquisition Expenses, 1956-1960* 
($000) 

1956 1957 1958 1959 1960 Total 



Salaries 

Planning and research $10 $ 75 

Technical services 5 25 

Travelling 10 15 

Communications - 5 

Other 



$150 


$350 


$275 


$ 860 


50 


100 


100 


280 


20 


30 


25 


100 


10 


15 


20 


50 


5 


50 


45 


100 



$25 $120 $235 $545 $465 $1,390 
♦Derived from corporate records. 



EXHIBIT 4 



Jet Aircraft Integration Expenses, 1956-1960* 



Advertising and promotion $ 3,600,000 

Salaries and wages (crew maintenance, sales and 

administration) 6,600,000 

Travel 1,000,000 

Communications 50,000 

Maintenance materials 300,000 

Outside services 150,000 

Stationery and supplies 300,000 

Plane rentals 1,600,000 

Insurance and taxes 450,000 

Maintenance provision 600,000 

Fuel and oil 950,000 

$15,600,000 

Annual breakdown only available in total, as below: 

1957 $ 100,000 

1958 850,000 

1959 10,400,000 

1960 4,250,000 

$15,600,000 

♦Derived from corporate records. 



309 



CASE 40 



Francono Cosmetics 
Company 



E 



arly in 1961, Mr. James Clair of Pittsburgh, Penn- 
sylvania, was attracted by an advertisement he 
read in The Wall Street Journal ( see Exhibit 1 ) . This advertisement of- 
fered for sale a relatively small cosmetics company located in Santa Paula, 
California. It was particularly appealing to Mr. Clair since he was plan- 
ning to retire from his executive position in Pittsburgh and had decided 
he would purchase a small business of his own to "tinker" with during 
his retirement years. He and his wife had decided that Southern Cali- 
fornia would be their choice of location for retirement. Mr. Clair had 
been trying to locate an opportunity to purchase a company for several 
years but had not been successful in his search up to this time, even 
though he had examined several prospective offers in detail. In order 
to better appraise this particular opportunity, Mr. Clair asked his son 
Rob, who had recently received a degree in business administration and 
was currently living in Riverside, California, to contact Francono Cos- 
metics Company and examine the company in as much detail as he felt 
would be necessary in order to advise his father relative to acquisition 
of the company. Subsequently, Rob Clair made an appointment with 
Mr. Francono to discuss the company's history and operation. 

COMPANY HISTORY 

Mr. Francono had started his cosmetics manufacturing company in the 
early 1920's at about the time of the advent of the motion picture in- 

310 



Francono Cosmetics Manufacturing Co., Inc. 311 

dustry. The company grew with the motion picture industry by supply- 
ing motion picture producers with various types of special make-up 
materials as well as lipstick, hair coloring, shampoo, nail polish, skin 
coloring, and so on. Francono Cosmetics Co. not only manufactured 
these items but also distributed them to the industry. Peak sales of nearly 
$10 million were reached in 1939, but after the war sales began to decline 
as other large manufacturing companies solicited the cosmetic business 
of the motion picture industry. 

These companies were able, through product research, to develop non- 
smear lipstick, all-day mascara, fluorescent nail polish to match any 
wardrobe, and other fashion cosmetics, whereas Francono continued to 
promote the same products it had pushed prior to 1941. Mr. Francono 
did not believe in "wasting money on hair-brained products that will 
never be accepted, ,, and because of this, no new cosmetic ideas or product 
improvements were introduced by Francono to the motion picture in- 
dustry. By 1955, the company's sales had declined to less than $1 million, 
and Mr. Francono decided to discontinue the manufacture of cosmetics 
and concentrate on selling other producers' products to his remaining 
customers. However, Mr. Francono found that he could not meet com- 
petitors' prices in selling to the motion picture industry, and in despera- 
tion he then decide to try selling cosmetics by mail in the retail market. 
The mail order sale of cosmetics commenced late in 1955 and grew 
from sales of only $500,000 in 1956 to sales of over $2 million in 1960. 
It was during 1960 that Mr. Francono, then in his early 70's, concluded 
that he would like to spend his retirement years traveling around the 
world and decided to sell Francono Cosmetics Company. 



MAIL ORDER OPERATION 

The sale of cosmetics by mail was a relatively simple operation. The 
principal selling medium was the sales catalogue which pictured and 
described each item Francono offered for sale. These catalogues were 
mailed to all names on selected mailing lists at various times during the 
year. Special Christmas and Easter catalogues featured not only gift- 
packaged women's cosmetics, but also listed such toiletries for men as hair 
cream, after-shave lotion, deodorants, and other similar items. These two 
"special" catalogues were far more comprehensive and costly to prepare 
than other mailings during the year, since these catalogues featured not 
only Francono's regular line, but also a large number of special items 
purchased especially for Christmas or Easter. These catalogues were 
printed in color, whereas the regular catalogues were printed in black 
and white. Color printing in itself tripled the cost of the special mailing. 

Mr. Francono stated that the costs of the regular and Christmas cata- 



312 Francono Cosmetics Manufacturing Co., Inc. 

logues were deducted as expenses in the year in which they were in- 
curred, but that since the Easter catalogue was sent out in December, 
this cost was capitalized and deferred until the succeeding year. The 
balance sheet as of December 31, 1960 (Exhibit 2) showed deferred 
catalogue expense of $210,000. Approximately $90,000 of this balance was 
the cost (including labor used in addressing the catalogue) of the 1960 
Easter catalogue, whereas $120,000 was the cost of the 1961 Easter 
catalogue. 

Both regular and special catalogues were mailed to each person on 
Francono's mailing list. The mailing list consisted of 2,600,000 names of 
potential customers which had been built up since 1956 by various 
means. Mr. Francono maintained that "this list is the heart of our busi- 
ness and is certainly the most important single asset we own. Its value, 
as shown on our December 31 balance sheet (Exhibit 2), is at cost, but 
I believe that each name on the list is worth at least $1, since the average 
of the annual purchase orders we receive from any one name is about 
$6." He further commented, however, that purchase orders were received 
from only 10 to 15 per cent of the names on the list during any one year, 
and if a name did not make a purchase during any three consecutive 
years, it was dropped from the list. Approximately 500,000 names were 
dropped from the list each year, but these names were replaced by new 
ones acquired in various ways. He estimated that between 650,000 and 
750,000 names formed a permanent base mailing list: each one of these 
names usually placed an order at least once during any three-year 
period. This permanent base list had increased each year since 1956. 
An analysis of the mailing list asset (Exhibit 2) showed the following 
breakdown: 



Cost Cost 

Incurred Incurred 

Prior to in 

1960 1960 

Names purchased from other mail order vendors. 
(The 1960 expenditure was for 500,000 replace- 
ment names plus 500,000 names to expand the 
list.) $375,000 $106,000 

Names secured through newspaper and magazine 
ads offering a free gift to those who sent name 
and address to a designated P.O. Box (included 
cost of gift items) 130,000 45,000 

Labor cost of purging ( deleting ) those names from 
the list that had not ordered for three consecu- 
tive years, and in eliminating duplicate names 
and following up change of address notices .... 40,000 10,000 

Totals $545,000 $161,000 

545,000 

Total cost of mailing list $706,000 



Francono Cosmetics Manufacturing Co., Inc. 313 

In addition to the "premium offer" advertising noted above, Francono 
Cosmetics purchased six "back cover" magazine ads, in a leading na- 
tional woman's monthly magazine, which had been run from September 
through December 1960 and were to run during January and February 
1961. The cost of these six ads, $300,000, had been capitalized as prepaid 
advertising on the December 31, 1960 balance sheet, since Mr. Francono 
anticipated that these advertisements would have a continuing impact 
on sales for a two- or three-year future period; this was the first time 
that full-page back cover advertising had been used by Francono. 

Each catalogue contained an order blank which was to be filled out, 
listing the items desired, and mailed back to Francono with a check 
covering the amount of the purchase. Francono then sent the merchan- 
dise to the purchaser. On occasion, the item which a purchaser requested 
would be out of stock, and in such case, Francono sent the purchaser 
a preprinted negotiable check (redeemable in cash at any bank) which 
showed the amount to be refunded to the purchaser or applied toward 
future purchase orders. However, these negotiable checks were not issued 
to a purchaser who returned defective or unsatisfactory merchandise to 
Francono for refund. In this case, a nonnegotiable refund voucher ( good 
only at Francono's in exchange on future purchases) was issued to the 
purchaser. Mr. Francono commented that it was a funny quirk of human 
nature, but some people never did cash in their refund checks or vouchers. 
He had a summary which showed, by year, the amount of checks and 
vouchers never redeemed as follows: 

Year Nonnegotiable Negotiable 

Issued Refund Voucher Amount Check Amount 

1956 $1,190 $ 560 

1957 1,250 720 

1958 1,700 1,070 

1959 2,090 960 

1960 2,880 1,900 

Total $9,110 $5,210 

No entry was made when either of these instruments was sent to the 
purchaser, and none was made when the nonnegotiable refund voucher 
was redeemed. In effect, this resulted in recognizing revenue at the time 
of the original sale and in recognizing the associated expense at the time 
when the credit instrument was returned for other merchandise. When 
the negotiable instrument was cashed, a debit was made to cost of goods 
sold and a credit to the cash account. 

Because Mr. Francono had founded the company and had grown up 
with it, he had never been very interested in "wasting good money on 
accounting overhead," and prided himself in the fact that he was "able 
to pretty much run the business out of my head," without the use of 
elaborate and detailed financial reports. He commented, "As long as our 



314 Francono Cosmetics Manufacturing Co., Inc, 

bank account has a positive balance, we're doing all right, and as can 
be witnessed by the growth of the cash account through the years, we 
have been running a profitable operation." 

As noted earlier, however, Mr. Francono had prepared a year-end 
balance sheet (Exhibit 2) and a profit and loss statement for the 1960 
calendar year (Exhibit 3). A cursory examination of these statements 
convinced Rob Clair that he would have to recast both statements before 
he could clearly appraise the year's operations. The balance sheet con- 
tained both 1959 and 1960 year-end balances, whereas the profit and 
loss statement appeared to be more of an accounting for cash rather than 
a matching of costs and revenues. 

Rob hoped that from the information he had obtained, he would now 
be able to prepare meaningful financial statements which would form 
the basis of his decision as to whether or not he should continue his 
evaluation of Francono Cosmetics Company, as a potential investment 
opportunity. 

Required 

1. Prepare revised financial statements which would be useful to Mr. Robert 
Clair in his appraisal of Francono Cosmetics Co. as a potential investment 
opportunity. 

2. Do you think that these statements would be useful to Mr. James Clair in 
helping him to arrive at a purchase price? If not, recommend the steps you 
would take to make them more meaningful and helpful to him. 



EXHIBIT 1 



Advertisement in The Wall Street Journal 



LOCATE IN SANTA PAULA, CALIFORNIA 

and still 

Net Over 20% on Your Investment! 



Well-known, firmly established, cosmetics manufacturer and 
distributor has decided to retire and will sell his profitable 
business to a responsible party. Sales of over $2 million per 
year with 50% gross and well over 20% net profit on invested 
capital. Unparalleled opportunity! All replies confidential. 

Box 



The Wall Street Journal 



EXHIBIT 2 Balance Sheet as of December 31, 1960 



Assets 

Cash and government bonds- December 31, 1960 $1,433,000 

Merchandise inventory— composed of cosmetic gift items 

not yet sold (at cost) as of December 31, 1959 . . 175,000 

Deferred catalogue expense 210,000 

Prepaid advertising 300,000 

Total current assets $2,118,000 

Fixed assets— net of depreciation (as of 1-1-60) 

Office furniture and equipment (10 yr. remaining life) $ 25,860 

Automobiles (3-year remaining life) 14,220 

Paintings— (nondepreciable works of art) 8,600 

Leasehold improvements* 110,300 

Mailing lists 706,000 

Total fixed assets 864,980 

Prepaid charges! 57,000 

Total assets $3,039,980 

Liabilities and Capital 

Mail order merchandise not paid for as of 12/31/60 .... $ 296,000 
Note payable— City National Bank (6% payable annually 

on December 31) 50,000 

Capital stock and surplus— (wholly owned by Mr. Francono) 2,693,980 

Total liabilities and capital $3,039,980 

*This was the remaining unamortized cost of certain improvements to the 
building which had been made in 1950. Mr. Francono was amortizing the cost of 
these improvements over their estimated life of 40 years. The present lease on 
the building and adjacent warehouse was in effect until January 1, 1975. 
t Prepaid charges as of January 1, 1960 

Prepaid insurance premium— applicable to period $ 3,500 

January 1, 1960 to July 1, 1960 

Office and shipping supplies inventory 13,600 

Postage— prepaid metering charges 3,900 

Prepaid rent— six months 36,000 

| 57^000 



315 



EXHIBIT 3 



Profit and Loss Statement for the Year Ending 
December 31, 1960 



Sales— $250,000 of sales orders were included, on which 
the merchandise would not be shipped until 

January 1961 $2,525,000 

Less cost of goods sold: 

Merchandise purchased during 1960* $1,465,000 

Less merchandise inventory 12-31-60 360,000 1,105,000 

Gross margin on sales " $1,420,000 

Less other operating costs: t 

Salaries and wages of employees. This amount did 
not include the December payroll of $12,850 
which was not recorded in the books until Jan- 
uary, but did include $3,500 of labor which was 
also charged to the deferred catalogue expense 
account $ 112,450 

Salary and expense account of Mr. Francono 76,000 

Heat, light, and power. Included December 1959 pay- 
ment of $3,500 but did not include December 
1960 billing of $6,300 53,400 

Insurance. Premium for a three-year policy cover- 
ing the building and contents from July 1, 1960 
to July 1, 1963 36,000 

Office and shipping supplies. An inventory of the 

storeroom showed that as of 12/31/60 $7,500 of 

these supplies had not been consumed during 1960 27,500 

Postage and shipping charges. Included prepaid 

metering of 3rd-class mailings of $7,600 as of 

December 31, 1960 76,250 

Cost of regular catalogue mailings— fall, winter, 

spring, and summer catalogues 126,300 

Cost of 1960 Christmas catalogues. Included all costs 
(labor, postage, and direct materials) associ- 
ated with the catalogue distribution 113,100 

Telephone and telegraph. Included billings for the 

10-month period January 1-October 31, 1960. . 6,800 

Rent on building and warehouse. For the period 

July 1, 1960- July 1, 1961 including an increase 
in the amount as stipulated in the lease con- 
tract 79,200 

Payroll and property taxes. Of this amount, $11,800 
had not been paid to the required agencies as 

of 12/31/60 19,600 726,600 

Net profit before tax $ 693,400 

*The merchandise purchased during 1960 ($1,465,000) included the cost of 
items used to redeem $6,300 of nonnegotiable refund vouchers, and included an 
accounting charge of $3,000 for the redemption of negotiable checks in cash. 
Two-thirds of the vouchers and checks had originally been issued in 1960, while 
one-third had been issued in prior years. 

fThe unpaid voucher file contained $8,150 of miscellaneous unpaid bills as of 
December 31, 1960, that had not been recognized in either the balance sheet or 
the profit and loss statement. 






316 



LIABILITIES AND RESERVES 



CASE 41 



Textron Inc. (E) 

Obligations Under Long-Term Leases 



i 



n March 1959, an article by Mr. Donald Gant en- 
titled "Illusion in Lease Financing" appeared in 
the current issue of the Harvard Business Review and aroused immediate 
and widespread controversy in financial circles of the business world. 
The thrust of Mr. Gant's article was that the recent rapid increase in 
the use of lease financing (a method of acquiring the use of an asset 
via a long-term lease rather than by purchasing it) was due to confused 
thinking on the part of many businessmen. Mr. Gant contended that 
lease financing was nothing more than another form of debt financing in 
that, in either event, the person acquiring the asset made a noncancelable 
promise to make a series of future payments which, in total, exceeded 
the purchase price of the asset. Leasing companies, on the other hand, 
did not usually compare lease financing to debt financing but stressed 
the additional profits the lessee could earn with the working capital 
"freed-up" by leasing. 

Mr. Gant placed much of the blame for confusion about lease financing 
on the accounting profession, pointing out that generally accepted ac- 
counting principles did not require a company to report its obligations 
for future lease payments as liabilities even though similar obligations 
on, for example, conditional sales contracts would be reported as debt 

317 



318 Textron Inc. (E) 

on the balance sheet. The article contained several examples of the sig- 
nificance of the lease obligations then outstanding for well-known com- 
panies in the retail chain store and the petroleum industries, and sup- 
ported Mr. Gant's contention that, if lease obligations were converted 
into an equivalent amount of debt and added to the conventionally 
stated liabilities, the corporation's financial ratios (particularly the debt/ 
equity ratio) would be substantially worsened. 

Mr. Royal Little, Chairman of Textron Inc., had been one of the lead- 
ers in the development of long-term leases as a method of corporate fi- 
nancing. At the date of merger with American Woolen and Robbins 
Mills, Textron was operating a total of 29 plants, of which 13 were owned 
by the company and 16 were held under long-term leases. Subsequently, 
as Textron expanded, new plants were typically acquired by purchase, 
although frequently a plant might be sold to an investor and leased 
back for a long period. At the end of 1958, Textron operated 68 plants, 
of which 30 were leased. By the end of 1959, the number of Textron 
plants had grown to 82, of which 34 were leased. 

As a result of the increasing public interest during 1959 in the report- 
ing of lease obligations, Textron's management decided to re-examine 
its policy concerning the disclosure of such obligations. In prior years, 
the company had included a footnote to the balance sheet in its annual 
report; for example, Note J in the 1958 report read as follows: 

Annual rentals payable under long-term leases are approximately 
$2,500,000. Under certain leases, Textron is also required to pay for 
insurance, taxes, and repairs. In 1958, certain machinery and equipment 
was sold at a profit of $1,003,163 and leased back for a period of seven 
years. 

As an alternative to the type of disclosure used in 1958, Textron was 
considering reporting the "discounted" or "present value" of all future 
lease obligations, the method of disclosure advocated by Mr. Gant and 
several other writers. 1 As a first step, the controller's department prepared 
a list of all leases in effect at the end of 1959. A summary of these leases, 
by type of item leased, is shown below: 

Rental Payments on 338 Leases 

Items Leased Paid in 1959 Due 1960-1979 

Land and buildings $2,245,000 $18,698,000 

Machinery and equipment 1,379,000 8,343,000 

Automotive equipment 1,027,000 1,329,000 

Office equipment 191,000 339,000 

Total $4,842,000 $28,709,000 



1 The method is explained in detail by Gordon Shillinglaw, "Leasing and Financial 
Statements," in The Accounting Review (October 1958), p. 581. 



Textron Inc. (E) 319 

The next step in the calculation, illustrated in Exhibit 1, was to recast 
the future payments according to the year due and to adjust for certain 
items. The total shown above of $28,709,000 was net of the anticipated 
revenue from the sublease of part of the plant operated by one of the 
divisions. The amount of this income was added back to determine 
Textron's total future obligations. The next two adjustments in Exhibit 1 
were to eliminate certain types of leases: those expiring within three years 
and those related to the lease of automotive equipment. The total pay- 
ments on leases expiring within three years, $2,141,000, included $1,246,- 
000 of lease payments for automobiles; the remaining $83,000 due in 
1963 on automobile leases was therefore eliminated as a separate step 
in Exhibit 1. These two categories of lease payments were eliminated 
because they were only short-term obligations and were typically re- 
newed on a year-to-year or two- or three-year basis. Textron's manage- 
ment subscribed to the theory that such short-term leases were not equiv- 
alent to debt but were more in the nature of annual operating expenses. 

A final adjustment in the calculation of Textron's future long-term 
lease obligations at the end of 1959 was to eliminate the future payments 
to be made on a lease renewal beginning in March 1961 and continuing 
for ten years. The original lease on this plant had been for ten years 
from March 1951 to March 1961, and Textron had an option to renew 
for an additional ten-year period. In December 1959, Textron notified the 
lessor that it intended to exercise the renewal option, but because the 
original term of the lease still had more than a year to run, the lease 
payments under the renewal provisions were excluded from the computa- 
tion at the end of 1959. 

Exhibit 2 (columns 1 through 4) illustrates the discounting procedure 
by which the $26,565,000 of future lease payments were reduced to a 
present value amount of $19,557,000. The theory behind this calculation 
was that a payment to be made in the future included an element of 
interest cost which should be eliminated in order to determine the equiva- 
lent principal amount of debt represented by the payment. Thus, al- 
though Textron was obligated to pay $3,061,000 in 1960, this amount 
might be considered to be a principal sum of $2,972,000 as of December 
31, 1959, plus $89,000 of interest (at 6 per cent) until the payment was 
due on June 30, 1960. Actually, of course, the $3,061,000 of 1960 payments 
would not be paid all at once on June 30, 1960, but would be spread 
throughout the year. To simplify the calculation, however, Textron de- 
cided to assume that each year's payments would be made in the middle 
of the year. The company also assumed that 6 per cent would be an 
appropriate interest rate for arriving at imputed interest costs, and that 
a semiannual compounding period was the best average period to use 
since some lease payments were made monthly, some quarterly, some 
semiannually, and some annually. 



320 Textron Inc. (E) 



Required 

1. Do you think the $19,557,000 of discounted future lease payments is an 
obligation similar to Textron's other debt obligations? Should Textron show 
this amount as a liability on its balance sheet? If so, should the offsetting 
entry to record the liability be a decrease in net worth or an increase in 
assets? If you do not think the lease obligations should be added to the 
liabilities, how should these obligations be disclosed, if at all? 

2. Do you approve of the various adjustments and assumptions made by 
Textron in computing the $19,557,000? 

3. Most of Textron's lease payments during a year were charged to "Cost of 
Goods Sold" in the Profit and Loss Statement. As can be seen in the last two 
columns of Exhibit 2, assuming that no additional leases were signed dur- 
ing 1960, the present value of the remaining future lease payments at the 
end of 1960 would be $17,596,000, a decrease from the end of 1959 of 
$1,961,000. Textron's lease payments during 1960 of $3,061,000 may thus 
be broken into two pieces: $1,961,000 of principal repayments on the 
equivalent debt and $1,100,000 of interest at 6 per cent on the "debt" out- 
standing during 1960. Do you think this imputed interest cost should be 
charged to Cost of Goods Sold or reported as additional interest expense 
below the Operating Profit line on Textron's income statement? 



EXHIBIT 1 



Computation of Total Long-Term Lease Obligations 
(All amounts in thousands) 

Total Due Due Due Due Due 

Future in in in in 1964- 

Payments 1960 1961 1962 1963 1979 



Net obligations $28,709 $4,608 $3,454 $3,312 $3,134 $14,201 

Add: Income on sublease 221 37 37 30 27_ 90 

Subtotal $28,930 $4,645 $3,491 $3,342 $3,161 $14,291 

Less: 

Payments on leases 

expiring within 

3 years $ 2,141 $1,584 $ 353 $ 204 

Payments on auto 

leases expiring 

after 3 years . . 83 $ 83 

years 
Early renewal of 

lease expiring in 

March 1960 . . 141 14 14 14 $ 99 

Total deductions. . $ 2,365 $1,584 $ 367 $ 218 $ 97 $ 99 

Total obligations 
on long-term 
leases $26,565 $3,061 $3,124 $3,124 $3,064 $14,192 



321 



EXHIBIT 2 



Computation of Discounted Value of Long-Term 

Lease Obligations at End of Year 1959 and Pro 

Forma End of 1960 

(In thousands) 







Discount 


Valuation on 


Discount 


Valuation on 


Year During 


Amount 


Factor 


Dec. 31, 1959 


Factor 


Dec. 31, 1960 


Which Payments 


of Lease 


6%, Semi- 


of Future 


6%, Semi- 


of Future 


Are Due 


Payments 


Annual* 


Payments 


Annual* 


Payments 


1960 


$ 3,061 


.9709 


$ 2,972 






1961 


3,124 


.9151 


2,859 


.9709 


$ 3,033 


1962 


3,124 


.8626 


2,695 


.9151 


2,859 


1963 


3,064 


.8131 


2,491 


.8626 


2,643 


1964 


2,458 


.7664 


1,884 


.8131 


1,999 


1965 


2,092 


.7224 


1,511 


.7664 


1,603 


1966 


1,482 


.6810 


1,009 


.7224 


1,071 


1967 


1,402 


.6419 


900 


. 810 


955 


1968 


1,023 


.6050 


619 


.6419 


657 


1969 


744 


.5703 


424 


.6050 


450 


1970 


662 


.5375 


356 


.5703 


378 


1971 


640 


.5067 


324 


.5375 


344 


1972 


636 


.4776 


304 


.5067 


322 


1973 


591 


.4502 


266 


.4776 


282 


1974 


583 


.4243 


247 


.4502 


262 


1975 


583 


.4000 


233 


.4243 


247 


1976 


564 


.3770 


213 


.4000 


226 


1977 


334 


.3554 


119 


.3770 


126 


1978 


308 


.3350 


103 


.3554 


109 


1979 


90 


.3158 


28 


.3350 


30 


Totals 


$26,565 




$19,557 




$17,596 



♦Financial Compound Interest and Annuity Tables, Financial Publishing Com- 
pany, Boston, 1942, p. 591. 



CASE 42 



Textron Inc. (F) 

Reserve for Self -Insurance 



i 



n January 1958, the controller of Textron Inc., was 
reviewing the company's accounting policy con- 
cerning the cost and liability of Textron's self-insurance plan, to be re- 
ported in the annual report to stockholders for 1957. Late in 1956, Tex- 
tron had decided to become a self-insurer for claims under workmen's 
compensation laws in certain of the states where it operated. These laws 
established the liability of an employer to compensate its employees in 
the event of disability accidents suffered by the employee on the job. 
Typically, employers protected themselves against claims under these 
laws by taking out an insurance policy which provided that, when an 
accident occurred, the employer's liability would be paid by the insur- 
ance company. 

Textron had decided to have certain divisions become self-insurers 
for these claims, as permitted by law, in order to lessen the total cost to 
the company. Essentially, the idea was to eliminate the insurance com- 
pany as a "middleman" in the payment of claims, and to permit Textron 
to earn the insurer's profit from taking the risk that the premiums paid 
in would be sufficient to cover the cost of the claims paid out. In the 
long run, of course, insurance companies had to charge the insured 
(Textron and other companies) sufficiently high premiums to pay all 
claims, so Textron's management was confident that the company's costs 

323 



324 Textron Inc. (F) 

under the self-insurance program would be lower, over a period of years, 
than if commercial insurance companies were employed. 

The premiums for ordinary workmen's compensation insurance were 
standard in the trade for each type of job and industry covered. These 
standard rates, charged by all insurance companies, were referred to as 
"manual" rates. Most insurance companies, while charging the manual 
rates, refunded a portion of the premium at the end of each year based 
on the volume of claims ("loss experience") paid in behalf of the in- 
sured. 

During 1957, Textron had accounted for the cost of workmen's com- 
pensation insurance by charging its divisions with premiums at the 
manual rate and crediting these amounts to a new account, "Reserve for 
Self-Insurance Claims." Claims by the divisions were paid during the 
year and charged against this reserve account. Reviewing the transactions 
in the reserve account at the end of the year, Textron's controller found 
that $330,245 had been credited to the reserve (and charged as an ex- 
pense to the divisions) and $101,792 had been paid out in claims. In 
addition, the reserve had been charged for (1) $11,799 for reinsurance 
premiums under a "catastrophe" policy to protect the company against 
all claims from any one accident exceeding $15,000, and (2) $37,197 
for fees paid to the Insurer's Service Corporation, a service organization 
which assisted Textron in the administration of its self -insurance program. 
Thus, the balance in the reserve account at the end of 1957 was $179,457. 

At the controller's request, Insurer's Service Corporation submitted a 
report in early 1958 stating Textron's estimated liability for unsettled 
claims as of December 31, 1957. This liability was estimated at $52,591 
and, in the opinion of Textron's controller, represented the minimum bal- 
ance that should be carried forward in the reserve account. Deducting 
this liability indicated that Textron had saved $126,866 by its program 
of self -insurance in 1957. The controller knew, however, that all reputable 
insurance companies provided contingency reserves against the possibility 
that claims in future years might exceed premium income. These reserves, 
in effect, were a protection against future losses, and had the effect of 
smoothing out the impact of the fluctuating volume of claims from year 
to year. 

For federal income tax purposes, only claims and other expenses ac- 
tually paid during a year were deductible from the corporation's taxable 
income for that year. 

Required 

1. What amount should be carried forward in the "Reserve for Self-Insurance 
Claims" at the end of 1957? 

2. What policy would you recommend that Textron follow in accounting for 



Textron Inc. (F) 325 

the cost of workmen's compensation claims and the reserve for self-insur- 
ance in future years? Draft a statement of this policy specifying how these 
costs and liabilities should be determined. 
3. What adjustment, if any, would you recommend to recognize the difference 
between each year's income tax deductions and the expenses charged in 
published financial reports? 






CASE 43 



Continental 
Minerals Company* 



A 



s of 1960, the Continental Minerals x Company 
had been engaged in nation-wide mining and 
manufacturing operations for many years. The Company operated a num- 
ber of plants under a "process" cost accounting system which the con- 
troller believed to be well ahead of the systems used by most similar 
companies in respect to the usefulness of the system in facilitating the 
control of manufacturing costs. Nevertheless, during several months of a 
recent business recession, the controller had decided to re-examine every 
aspect of the company's cost control system. As a part of his re-examina- 
tion, he had arranged a meeting of three plant works managers, three 
plant office managers, and three representatives of the home office operat- 
ing management. 

At the conclusion of the meeting several basic areas had been found 
in which improvements in the current cost control system were thought 
to be possible. One of the areas was that of certain erratic costs which 
bore no consistent relationship to current levels of monthly production. 
Three classifications of costs were identified as being of this nature: (1) 
vacation and other un worked paid holidays, (2) certain administrative 



* Copyright 1960, De Paul University. This case was prepared by Dr. Russell 
Bowers of De Paul University and has been made possible through the cooperation 
of the University of Chicago, De Paul University, and Northwestern University and 
the Chicago Control of the Controllers Institute of America. 

1 All names, figures, and organizational designations have been disguised. 

326 



Continental Minerals Company 327 

and service costs incurred at the plant level, and (3) non-routine main- 
tenance. (Non-routine maintenance was defined as any maintenance job 
which was covered by a special budget and cost over $500. ) The matter 
of maintenance cost was selected for immediate investigation. 

A distinction was made in the Continental Minerals Company between 
routine and non-routine maintenance. Routine maintenance consisted of 
such work as oiling, greasing, and repair work of a regular nature. This 
class of maintenance varied with the level of operations. The typical non- 
routine maintenance cost consisted of expenditures for the renewal of 
parts at irregular intervals— expenditures which were not to be charged 
to the asset or depreciation reserve accounts. 

In studying the control of these costs, it was found that there was 
an apparent tendency for maintenance expenditures to be greater in 
months of high production volume. This pattern had the effect of minimiz- 
ing the impact of maintenance expenses per unit costs of products— the 
product could "bear" heavier maintenance costs during months of high 
volume. During the meeting mentioned above, one of the works man- 
agers had suggested that the company might get more for its maintenance 
expenditures if those expenditures were made during periods of low 
volume production. Such benefits might result from better planning of 
work, less overtime maintenance work, and less interference with pro- 
duction. 

All expenditures of funds for maintenance purposes were approved by 
the home office. When volume of production fell materially below ex- 
pected levels, the home office frequently canceled prior approvals of 
maintenance expenditures in cases where the funds had not yet been 
expended. The works managers had argued that these slack periods 
were the ideal times to perform maintenance, and they wondered whether 
it might be possible for maintenance to be performed during periods of 
low production without having the maintenance expenses reduce still 
further the lower profits which would be reported during such periods. 

Shortly after these discussions, the controller outlined a different ap- 
proach which he thought Continental Minerals might follow with respect 
to its maintenance charges. Under the new proposal, non-routine main- 
tenance expenditures would be budgeted for the forthcoming year. The 
system also required each plant to estimate the volume of production 
in each of its departments for the entire calendar year in advance. The 
annual volume estimates thus made would be revised and updated as 
necessary each month. A portion of the annual maintenance budget 
would be charged into costs, each monthly charge being determined 
by the ratio of the current month's production to the expected annual 
volume. Thus if the maintenance budget of a given department for the 
year were $120,000 and estimated annual volume were 1,200,000 tons 
of product, the monthly charge for maintenance would be $.10 times 



328 Continental Minerals Company 

the actual tons produced, regardless of actual maintenance expenditures. 
If a revised estimate of annual production were required during the 
year, a revised charge for maintenance would be made. For example, 
assume that actual production for the first four months of the year were 
charged with maintenance cost at $.10 a ton as follows: 

Maintenance 
Tons Charged to Costs 

January 60,000 $ 6,000 

February 55,000 5,500 

March 70,000 7,000 

April 40,000 4,000 

Total for four months 225,000 $22,500 

If it were estimated in May that the total annual production would be 
1,005,000 tons instead of the 1,200,000 tons estimated earlier, then for 
the remainder of the year maintenance cost per tons would be $.125 a 
ton for the remainder of the year computed as follows: 

Maintenance 
Tons Cost 

Revised total 1,005,000 $120,000 

Less actual to date 225,000 22,500 

Estimate for remainder of year 780,000 $ 97,500 

$97,500 -f- 780,000 = $.125 

As actual production occurred, the estimated maintenance cost per 
ton would be charged to the cost of the product for the month and a 
"Reserve for Maintenance" credited for a like amount. Actual expendi- 
tures would then be debited to the Reserve for Maintenance as they 
were made. At the close of the year, any balance in the Reserve for 
Maintenance account would be closed as an adjustment to the total 
maintenance cost for the year as a whole. It would not be treated as an 
adjustment for the last month of the year. 

In his study of the problem of maintenance charges and their effects 
on Continental's operations, the controller considered a specific situation 
which had come to his attention from time to time. Near one of the 
Company's mining operations in a somewhat remote part of the country, 
the company had built a village with housing, stores, and roadways to 
attract an adequate labor force to the area. A utility company in the 
area, Western Power and Light Company, supplied electric power at a 
point some distance from the dwellings in the village where the power 
would be used. Consequently, rather extensive power installations had 
to be constructed and maintained at the expense of Continental to bring 
power into the village. The Company was thus faced with the task of 
developing a representative cost of power to determine whether the rates 



Continental Minerals Company 329 

charged to residents were sufficient to cover cost of providing the service. 
In attempting to provide data for the cost of supplying electricity, it was 
observed that the erratic nature of maintenance expenses resulted in costs 
which for short periods of time were almost useless. A generally recog- 
nized problem of the current system was the necessity of time-consuming 
explanations of monthly variances in power costs due to erratic main- 
tenance costs. 

The controller contended that such an "accounting smoothing" device 
as a "Reserve for Maintenance" would help solve this difficulty. He added 
the opinion that going to a reserve or accrual basis for maintenance 
would also result in a better matching of cost with volume of production 
and hence with revenue. Also the disproportionate time now spent in 
analyzing and explaining changes in cost, resulting from uneven main- 
tenance expenditures, could be saved. 

Required 

1. Evaluate the company's new policy of accounting for irregular maintenance 
cost. 

2. In general, is an "accounting smoothing" device for expenses to be com- 
mended? 

3. Is it proper in accounting to divorce costs based on historical expenditures, 
including commitments, from accrued costs based on mere expectations? 

4. Does the method of tying maintenance cost to actual production, and hence 
sales, have validity in the process of matching expense and revenue? 

5. Should the "accounting smoothing" device of a Reserve for Maintenance be 
carried beyond the current year? 

6. If the maintenance budget were for a period longer than a year, how would 
you treat any debit or any credit balance in the Reserve at the end of the 
year? Justify. 



CASE 



44 



Russey 

Electrical Service Company 



R' 



ussey Electrical Service Company had for many 
years operated a service organization which per- 
formed service work on all forms of electrical appliances. The work was 
performed for individual owners of appliances on a service-charge basis. 
Early in 1954, it decided to add a sales organization for the purpose of 
marketing certain appliances under its own brand name. It bought these 
appliances under contract from various manufacturers who built them to 
the specifications of the Russey Company. In its sales program, the com- 
pany placed great emphasis on a liberal warranty provision under which 
it agreed to make any and all adjustments and repairs for a two-year 
period. Such repairs were made by its service department and charged 
as costs of that department. 

Results exceeded expectations. Sales had risen steadily year by year, 
and the management expected them to continue to increase in subse- 
quent years. There was, however, some growing question as to whether 
the effect of the liberal warranty was being given adequate recognition 
in evaluating the results of operations and a feeling that the company's 
profits as shown on its books were misleading. The appliances purchased 
and sold by the company were generally in the novelty or "gadget" 
category and required rather frequent adjustment and repair. The com- 
pany recognized that its increasing sales record was due, in substantial 
measure, to the unconditional two-year guarantee to perform free of 
charge any and all adjustments and repairs. 

330 



Russey Electrical Service Company 331 

Prior to closing the books and preparing the 1956 financial statements, 
a management conference was held to review the situation. The follow- 
ing summary of the results of operations for the past four years, as shown 
by the company's books, was reviewed and discussed: 

1953 1954 1955 1956 

Appliance sales $300,000 $390,000 $ 500,000 

Service department revenue . . $600,000 575,000 560,000 580,000 

Total revenues $600,000 $875,000 $950,000 $1,080,000 

Cost of appliance sales and 

direct selling costs $180,000 $235,000 $ 300,000 

Service department costs $450,000 447,000 470,000 515,000 

Total direct costs $450,000 $627,000 $705,000 $ 81 5,000 

Gross profit $150,000 $248,000 $245,000 $~265^000 

General and administrative 

expenses $ 70,000 $100,000 $120,000 $ 130,000 

Federal income taxes* 32,000 59,200 50,000 54,000 

$102,000 $159,200 $170,000 $ 184,000 

Net profit $48,000 $ 88,800 $ 75,000 $ 81,000 



* For purposes of this case, an arbitrary income tax rate of approximately 40 per 
cent has been used in determining the annual income tax. You may use this arbitrary 
rate in dealing with any income tax aspects involved. 

The president said his immediate concern was that the total net in- 
come and retained earnings figures, as developed by the company's books 
and statements, were misleading both to management and as a basis of 
disclosure to the company's stockholders, in that the company was taking 
up appliance sales as income without giving adequate recognition to the 
warranty phase of the sales program. His attention was called to the fact 
that the present basis of accounting for revenues and expenses was con- 
sistent with Federal income tax requirements, in that revenues were 
recorded as received and expenses as actually paid or incurred. The 
president felt, however, that requirements for computing income taxes 
should not prevent the development of realistic figures in the company's 
books and statements, and that they should not prevent application of 
generally accepted accounting principles in disclosing the results of its 
operations and its present financial condition. 

The service department manager criticized the figures from the stand- 
point of management usefulness. He pointed out that service depart- 
ment costs included work performed without charge under the war- 
ranties, and that no provision was made to include anything in service 
department revenues for such work. This, he pointed out, made any 
comparison between service department revenues and costs almost mean- 
ingless in interpreting the contribution made by that department to the 
net profit of the company. In fact, he pointed out, his department had 
lost some regular revenue business because of the demands for "free" 



332 Russey Electrical Service Company 

service work under the warranties. He felt that consideration should be 
given to reflecting in service department revenues charges for warranty 
work on the same basis as for regular service work. 

You have been asked to review the situation and to make appropriate 
recommendations. Your first step is to get together with the bookkeeper 
and the service manager to make an analysis of costs and revenues. The 
company did not keep formal cost records by jobs, but informal memo- 
randum records kept by the service department provided an adequate 
basis for sampling and the development of what you may regard as a 
reliable analysis. The following information was developed from this 
analysis: 

1. The service department continued to maintain a fairly constant 
markup for regular service work (of 33% per cent on cost), with the 
result that costs for this work continued to maintain approximately the 
same relationship to related revenues indicated by 1953 operations ( that 
is, 75 per cent). 

2. An analysis was made to determine the warranty service costs in- 
curred in 1954, 1955, and 1956 on sales made in 1954. This showed that 
total warranty service costs incurred on 1954 sales over the warranty 
period amounted to about 20 per cent of such sales (5 per cent in 1954, 
10 per cent in 1955, and 5 per cent in 1956 ) . A similar analysis was made 
of warranty service costs incurred in 1955 and 1956 on 1955 sales, and 
costs incurred in 1956 on 1956 sales. This further analysis indicated rather 
clearly that the pattern of warranty service costs in relation to sales estab- 
lished for 1954 sales would also apply to 1955 and 1956 sales. It was 
therefore felt that projections of estimated future warranty costs could 
be made on that basis. The following schedule summarizes the results 
of these analyses and projections. (You may assume these to be reliable 
figures for purposes of this case. ) 

Projections of Esti- 
mated Warranty 
Service Costs in 
Warranty Service Future Years on Past 

Costs Incurred in Sales 

1954 1955 1956 1957 1958 

1954 sales $15,000 $30,000 $15,000 

1955 sales 19,500 39,000 $19,500 

1956 sales 25,000 50,000 $25,000 

Totals $15,000 $49,500 $79,000 $69,500 $25,000 



Required 

1. Develop your comments and recommendations with regard to the com- 
pany's accounting and financial reporting. It will be helpful if you can be as 
specific as possible, keeping in mind that the company has not closed its 



Russey Electrical Service Company 333 

books or prepared its formal financial statements for 1956 and that it wants 
guidance as to what entries it should make at that time to give effect to your 
recommendations, as well as with respect to the accounting procedures it 
should follow in the future. 

If there are reasonable alternatives the company might adopt, it is sug- 
gested you mention them and indicate your reasons for the action you 
recommended. 






B. Multi-Policy Formulation for the Business Enterprise 



CASE 45 



The 

Boston Patriots 



E 



arly in August 1960, Mr. Roger Dolan, an execu- 
tive of a medium-size electronics firm, was given 
a prospectus for the American League Professional Football Team of 
Boston, Inc., commonly referred to as the "Boston Patriots," by his broker, 
one of the underwriters of the stock referred to in the prospectus. After 
a cursory examination of the prospectus, Mr. Dolan became interested 
in the Patriots as a speculative investment opportunity and after an in- 
tensive examination of the prospectus and other research, he was able 
to assemble certain information which he thought would be an adequate 
base for his investment decision. 

THE AMERICAN FOOTBALL LEAGUE 

The prospectus stated that, "The American Football League was or- 
ganized in August 1959 as a professional football sports organization and 
since that time has granted franchises to teams in eight cities including 
Boston (see Exhibit 1). Each team is now organized with a general 
manager, coaching staff, home stadium, a full squad of players, and is 
ready to begin performance as of September 1960." 

The football season commencing September 1960 was to be the league's 
first season, and the schedule called for each team to play each of the 

334 



The Boston Patriots 335 

other seven teams once at home and once away. Several preseason 
exhibition games were to be played by League teams, and a postseason 
championship game between the winners of the Eastern and Western 
Divisions of the League was also planned. 



ORGANIZATION OF THE BOSTON PATRIOTS 

The prospectus stated that the Boston club's franchise had been granted 
to William Sullivan, Jr. in November 1959, and was the eighth franchise 
awarded by the American Football League. The Club was incorporated 
in Massachusetts in March 1960, and was authorized to issue 100,000 
shares of Class A common stock and 150,000 shares of common stock. 
Both classes of stock had a $1 par value and were identical in every 
respect except that only the Class A stock carried voting rights. Mr. 
Sullivan, Jr. and nine other prominent New England businessmen each 
purchased 10,000 shares of the Class A stock for $2.50 per share. 

As described in the prospectus (see Exhibit 2), the Patriots offered 
120,000 shares of nonvoting common stock to the public at $5 per share. 
The Patriots hoped that this public stock offering would stimulate interest 
in the Patriots' football team and would also broaden their financial base. 
The underwriters of the stock anticipated that the entire issue would 
be sold immediately and that the remaining 30,000 shares of authorized 
common stock would not be offered for public sale. 

Relative to the cost of obtaining the League franchise, the prospectus 
stated that, "The Patriots paid the American Football League $25,000 
for the Boston franchise (the right to play football in the American 
League) which can be held by the company for the purpose of conduct- 
ing a professional football business, or can be sold by the company to 
another person or group of persons at any agreed-upon price. However, 
any proposed transfer of franchise must be approved by an 80 per cent 
vote of the League members. In addition to the original payment, the 
League will receive an annual membership charge of $1,000 from each 
team and 3 per cent of the gross gate receipts from each preseason and 
regular season League game. The League will also receive 15 per cent 
of the gross receipts from the postseason championship game. If the 
League requires additional funds to meet its expenses, each team may 
be assessed equally to meet any such deficit." 

The Patriots signed Edward McKeever as general manager under a 
one-year contract for a $20,000 annual salary. Mr. McKeever had been 
the head coach at Notre Dame, Cornell, and the University of San Fran- 
cisco, and more recently had been engaged in public relations work. 
He stated his business philosophy very simply by saying, "Winning foot- 
ball games is not the most important thing in this business, it's every- 



336 The Boston Patriots 

thing! It's not enough to just put on a good show, you have to give the 
public victories so they can say, 'That's my team— they are at the top- 
nothing but the best/ and I think our team can do it." He went on to 
say that several of the Patriots' players had outstanding records, for 
example, Tommy Greene of Holy Cross, a very capable quarterback, 
Butch Songin, a former first team National League player and highly 
regarded passer, and Jim Colclough of Boston College. 



ANTICIPATED OPERATING EXPENSES 
FOR THE BOSTON PATRIOTS 

The prospectus included a "Statement of Assets and Unrecovered 
Promotional Costs" and a "Statement of Cash Receipts and Disburse- 
ments" from the date of incorporation through June 30, 1960. These 
statements are reproduced in Exhibit 3 and Column 1 of Exhibit 4. 

In addition to these expense figures, Mr. Dolan was able to obtain 
certain additional expense information from conversations he had with 
the management of the Patriots. (Columns 2 and 3 of Exhibit 4 sum- 
marize this information.) 



PLAYERS TRAVEL ADVANCES, SALARY ADVANCES, AND BONUSES 

The Patriots started preseason training with a squad of 100 players 
which was to be gradually reduced to the League maximum of 33 players 
by the start of the regular 1960 season. Players were acquired by means 
of a draft system wherein the American League bid against the National 
League for players. In order to induce a player to sign up with the 
Patriots, he might be offered a "bonus" payment in addition to any salary 
he might receive. The bonus was paid to him at the time he showed up 
for practice and was his, even if he was later released by the team. 

The Patriots paid out $27,975 in bonuses to the 100 players who 
showed up for practice. The three top bonuses were $7,500, $6,000, and 
$4,900, respectively. Each of these three players was signed to a two- 
year contract with an option to renew his contract for additional periods 
at a salary of not less than 90 per cent of the original salary contract 
amount. All other players were signed to one-year contracts with options 
to renew at not less than 100 per cent of the original contract amount. 
The contracts of the top three bonus players contained nonrelease clauses 
binding on the club. The other 97 players could be released (dismissed) 
by the team manager, thus relieving the club from the responsibility of 
honoring the salary contracts. 

In addition to the bonus payments, salary and travel advances of 
$10,508 were made to 28 of the original 100 players. These advances 



The Boston Patriots 337 

were to be deducted from future salary payments and were not con- 
sidered as bonuses. However, by August 1960, 9 of these 28 players had 
already been released and it was doubtful that their advances amounting 
to $4,318 would be recovered. 



SALARIES AND WAGES 

As noted in the prospectus, Mr. McKeever received a one-year con- 
tract for $20,000 and Lou Saban, head coach of the Patriots, signed a 
three-year contract for an aggregate payment of $50,000. If, for any 
reason, Mr. Saban was relieved of this position before his three-year 
contract expired, he was still to receive the $50,000 contract amount. 
Mr. Sullivan received $25,000 for services rendered through the end of 
1960 and had accepted a salary of $20,000 for the season. Mr. McKeever 
commented that $15,000 (as shown in Exhibit 4) of Mr. Sullivan's 1960 
salary was remuneration for expenses he incurred in obtaining the League 
franchise, $5,000 was payment for the time he spent in organizing the 
team, obtaining its financial backing, and scouting for prospective foot- 
ball players, and the remaining $5,000 was his salary as president for 1960. 

Administrative and office salaries, in addition to those of Mr. McKeever 
and Mr. Sullivan, were expected to total $46,500 annually, and coaching 
salaries over and above Mr. Saban's were anticipated at $42,000 an- 
nually. 

No salaries were paid to any players during preseason training, but 
the contracted salary amounts were to be paid to each of the retained 
33 players during the regular season. The players' salaries ranged from 
$7,000 to $15,000, with an average salary of $8,760. The salary contract 
provided that each player was to receive %4 of 75 per cent of his con- 
tracted salary at the end of each game and the final 25 per cent at the 
completion of the season. 

OFFICE EXPENSE 

The Patriots leased office space at 520 Commonwealth Avenue, Boston, 
to be used for ticket sales and as their administrative headquarters. They 
signed a three-year lease on the space for $750 a month and made certain 
improvements and changes to the building. They repartitioned the inte- 
rior space, remodeled and added to the front of the building, painted 
inside and out, and added certain plumbing facilities. These improve- 
ments were expected to cost a total of $4,600, of which $2,850 had been 
paid to the contractor prior to June 30, 1960. The physical life of the 
improvements was estimated at 15 years. 

Desks, filing cabinets, typewriters, adding machines, and other office 



338 The Boston Patriots 

equipment costing $4,055 were purchased for use by the office staff. The 
estimated life of all the equipment was five years, with an estimated 
scrap value of approximately 10 per cent of original cost. 

A 1960 Chevrolet was obtained under a one-year lease from a local 
automobile dealer. The annual rental under this lease was $1, and the 
annual operating and maintenance expense for the car was expected to 
amount to $750. 



ADVERTISING AND PROMOTION EXPENSE 

The cost of scouting for new players, including entertainment of pro- 
spective players, dining with college coaches, and complimentary travel 
passes to Boston, amounted to $22,300 for the 1960 season and was not 
expected to change materially in succeeding years. This amount included 
the cost of entertaining the press, state dignitaries, and other V.I.P.'s. 

The cost of promotional leaflets, game schedules, photos, newspaper 
advertising, publicity letters, handouts, and various other types of promo- 
tional devices had amounted to $9,795.17 by June 30, 1960. Mr. Moore, 
director of public relations, stated that this amount represented 75 per 
cent of the annual amount he had budgeted for this purpose. He further 
commented that approximately $4,800 of this budgeted figure was the 
anticipated cost of 35,000 programs to be sold at the season games. Mr. 
Moore's annual salary of $7,500 was included in the figure for administra- 
tive and office salaries, noted earlier. 



COST OF PROFESSIONAL SERVICES AND INSURANCE 

The prospectus stated that, "The corporation has agreed to indemnify 
Boston University against certain liabilities which may be assessed against 
it as a result of the use of its field by the Patriots, but not in excess of 
$150,000. The Patriots have agreed to deposit $50,000 cash in a trust 
account which will then be used as security for this indemnity agree- 
ment/' Mr. Sullivan stated that he was unable to estimate the possible 
liability under this agreement, and no policy could be obtained to insure 
against this liability. Only the maximum limit was certain. 

The corporation posted a surety company performance bond for $100,- 
000 with the League to guarantee that the Patriots would field a team 
and play each scheduled game during the season. This performance bond 
cost the Patriots $2,000. 

Liability insurance for protection against lawsuits brought about by 
injury to either players or spectators at games was purchased by the 
Patriots at a total cost of $22,000. This amount provided for a three-year 
contract that required annual payments of $10,000, $7,000, and $5,000, 



The Boston Patriots 339 

respectively, during the first three years. The coverage provided under 
this contract was deemed sufficient to cover any liability incurred by the 
Patriots. The contract provided for equal coverage during each of the 
three years. 

A certified public accountant was engaged to design the system of 
accounts and to prepare interim financial statements for the Patriots. His 
fee for installing the accounting system was $750 and his annual retainer, 
for preparation of financial reports, was set at $1,000. A legal advisor 
was retained at a cost of $500 per month on March 1, 1960. 

The CPA commented that some amount would have to be set up as 
organization expense and amortized over a period of time of not less 
than 60 months as set forth in Section 248 of the Internal Revenue Code. 
It was his feeling that the entire SEC registration expense of $21,000, 
and some portion of the accounting and legal fees, should be capitalized 
since these were costs associated with establishing the company, not 
costs of current operation. However, the Patriots' management felt that 
since these were out-of-pocket costs, they should be charged off against 
current operations. The legal advisor stated that it was common practice 
in most new business enterprises to capitalize some minimum amount, 
say $500, and expense everything else. He said that this would be ad- 
vantageous in the light of corporate income taxes. 



STADIUM EXPENSE 

The Patriots contracted to use Boston University's football field for all 
home games on a rent-free basis. However, they agreed to make certain 
improvements to the field and bear one-half the cost of such improve- 
ments themselves as well as to maintain the field in good playing condi- 
tion. They agreed to bring the seating capacity up to 25,000, install 
adequate lighting facilities for night games, build and equip press, radio, 
and television broadcasting boxes, and make certain other improve- 
ments to the field. The anticipated total cost of such expenditures was 
$400,000. 

The lease contract with Boston University provided that the Patriots 
could use the field for the 1960 and 1961 seasons with an additional two- 
year renewal option available at that time, with no further improvements 
required under such contract. Mr. McKeever pointed out that a group 
of private individuals was considering the construction of a $25 million 
sports stadium with a retractable metal dome, an attached hotel, swim- 
ming pool, and nightclub, adequate parking facilities, and with a capacity 
well over 50,000. He estimated that if this group decided to build such 
a stadium, it would be completed by June 1962. In view of the limited 
capacity, inadequate parking facilities, and other temporary arrange- 



340 The Boston Patriots 

ments of their present home field, the Patriot's management welcomed 
the construction plans for such a stadium and offered to lease it, when 
and if built, for $100,000 per year. 



TRAINING CAMP EXPENSES 

The cost of the football training camp for the 1960 season was esti- 
mated at $55,000 annually by Mr. Saban. This included the cost of food, 
lodging, uniforms, and training equipment at the camp. 

A contract, signed with the University of Massachusetts at Amherst, 
permitted the Patriots to use the University's field for training purposes 
in exchange for certain training equipment purchased by the Patriots. 
This was a one-year contract with an option to renew for two additional 
years. The equipment given to the University at the end of each playing 
season consisted of tackling dummies, blocking racks, certain sound 
equipment, and other smaller pieces of athletic equipment. The equip- 
ment cost $8,300 in 1960, but it was anticipated that only $3,800 would 
be needed, during each of the two succeeding years, to maintain the 
same amount and quality of training equipment used during 1960, be- 
cause some of the previous season's equipment could be reused during 
the following years. 

Players' uniforms cost $13,900 for the 1960 season. This amount in- 
cluded the cost of practice uniforms, game uniforms, football helmets, 
kneepads, and shoulderpads. Many of the training uniforms would be 
worn out at the end of the 1960 season, and the 1960 game uniforms 
would probably be used as practice uniforms in 1961. The cost of replac- 
ing the game uniforms, damaged equipment, and purchasing odd-size 
uniforms was estimated at $7,400 for each year succeeding 1960. 



ANTICIPATED INCOME FOR THE BOSTON PATRIOTS 



TELEVISION RIGHTS 

The prospectus stated that, "The League entered into a contract in June 
with the American Broadcasting Company covering the sale of television 
rights to all 1960-1964 regular season and championship games. The 
amount to be paid to the League by ABC depends upon the percentage 
of sponsorship of broadcasts of the games varying from $965,000 at 50 
per cent to $2,120,000 at 100 per cent. The Patriots have been informed 
that, to date, 100 per cent of the broadcasts for 1960 have been spon- 
sored and that at least 50 per cent of the broadcasts anitcipated for the 
succeeding four years have also been sponsored. Each League team will 



The Boston Patriots 341 

receive % of the total television contract payments, payable in equal in- 
stallments in October, November, December, and January. Under the 
contract, ABC must pay 10, 5, 10, 5 per cent over the sponsorship 
amounts ($965,000 at 50 per cent and $2,120,000 at 100 per cent) called 
for the preceding year during the period 1961-1964. Home games will not 
be televised in New England but at least three of the Patriots' away 
games will be televised in this region." 



RADIO RIGHTS 

The Patriots arranged to have all their home and away, exhibition and 
regular season games during the first three seasons broadcast over WEEI. 
They were to receive $9,000, $10,000, and $11,000 in the years 1960- 
1962, respectively, for the sale of these radio rights. 



CONCESSION RIGHTS 

An independent concessionaire agreed to take over the concession 
operation for the Patriots at their home games. All concession income be- 
longed solely to the home team. The contract specified that the Patriots 
were to receive 25 per cent of the gross sales of food, novelties, drinks, 
and pennants as their payment for granting exclusive concession rights 
to the concessionaire. The contract further guaranteed the Patriots a 
minimum income of $350 per game if attendance exceeded 5,000 and no 
income if attendance was less than 5,000. Based on his experience, the 
concessionaire stated that he anticipated typical concession sales for an 
attendance of 12,000 would be from $2,200 to $2,800. The closer the at- 
tendance at the game approached capacity, the less would be the antici- 
pated dollar purchase per person, he said. 

The concessionaire also contracted to sell football programs at the 
games for a 20 per cent commission. The programs sold for 50 cents 
each, and the concessionaire anticipated that from 25 per cent to 35 
per cent of the attendance at each game would purchase programs. 



GATE RECEIPTS 

The gate receipts were based upon the attendance at both home and 
away games and were described in the prospectus as follows : "Under the 
constitution and bylaws of the League, which bind all teams, the home 
team guarantees the visiting team $20,000, or 40 per cent, of the net gate 
receipts, whichever is greater. At the date of this prospectus approxi- 
mately 1,820 season tickets to the 1960 home games have been sold at 



342 The Boston Patriots 

$35 each. Tickets to the home games, all to be played on Friday evening, 
will sell for an average price of $5 each. At the date of this prospectus, 
it is impossible to make any estimate of the income from ticket sales/' 

Boston University Field, where the Patriots were to play all home 
games, had a capacity of 25,000 seats, comprised of 5,000 end-zone seats 
at $4 each, 1,500 box seats at $6 each, and 18,500 reserved grandstand 
seats at $5 each. The Patriots' season schedule of all games was also 
given in the prospectus (see Exhibit 5). 

The Patriots were the sixth professional football team to be established 
in Boston. The first team was organized in 1926 and the latest one, prior 
to the Patriots, was attempted in 1944. All these teams failed financially 
primarily due to a lack of public support. The aggregate total losses of 
these previous teams was several hundred thousand dollars. 

As noted above, the last attempt to establish a professional football 
team was made in 1944. Mr. Ted Collins, a business manager for Kate 
Smith and other entertainment personalities, purchased a National 
League Football franchise for $50,000 and formed the Boston Yanks. 
During the next five years, the team's record was 14 wins, 38 losses, 3 
ties, and a substantial loss for its owner. (Attendance figures for the 
Boston Yanks are given in Exhibit 6. ) Mr. Collins took the team to New 
York in 1949 and again incurred a loss during the next two years. He sold 
the franchise to Dallas, Texas, for $100,000 in 1951 and later this team 
failed. The franchise then went to Baltimore, where the Colts were such 
a success that the 1960 season tickets were sold out months before the 
season opened. 

Before trying to organize a new team in Boston, Mr. Sullivan had 
studied the past failures very carefully. In his opinion, the prime reason 
for past failures had been the lack of public support in the form of at- 
tendance which could be attributed to two factors. First, many of the 
previous teams had failed because they were newly organized with thin 
financial backing, and had tried to compete in a firmly established league 
for top-notch players. Since victory was so important to a team's success, 
the pitting of an inexperienced team against a well-organized, well- 
balanced club was bound to end in failure unless the team could rapidly 
establish itself. Likewise, a mediocre team in a newly formed league that 
offered no outstanding drawing card, either in the form of a well-known 
player or a big-name team, had difficulty attracting spectators. Mr. Sulli- 
van felt that, because the Patriots had strong financial backing and be- 
cause they were able to offer new players a spotlight position, rather 
than a third- or fourth-team position, they would be able to attract 
the outstanding players necessary for public support. Second, Mr. Sullivan 
felt that competition from local college and university teams and from 
other major sports organizations had affected the attendance at profes- 
sional football games. In elaboration of this factor, Mr. Sullivan thought 



The Boston Patriots 343 

that all the teams in the new American Football League would be com- 
peting for the public's sports dollar with several other major sports or- 
ganizations. First, and probably most formidable would be the National 
Football League composed of the teams listed in Exhibit 1. The National 
League was a well-established, widely accepted sports organization 
whose attendance increased more than 50 per cent between 1952 and 
1958 and was in excess of 3 million paid attendees in 1959 ( or an average 
of nearly 44,000 attendees as compared with an average of slightly over 
25,000 attendees in 1949). Ten of the twelve teams operated well in the 
black during 1959, and two of the teams had sold all their season tickets 
for 1960. The National League teams were comprised of many well- 
established and widely known football personalities such as Johnny 
Unitas of Baltimore, Charlie Conerly of the New York Giants, and Jimmy 
Brown of Cleveland. Because most of these football personalities were 
spoken for and tied by contract to the National League, the American 
League had been forced to sign predominantly graduating college seniors 
and some former Canadian professional players who were not as well 
known as many National League players and thus provided less attrac- 
tion to the public. 

The American League also expected competition from National League 
games broadcast over TV, because the public had the option of watching 
American League football live or National League football over TV on 
Sunday afternoons at most of the away games. Mr. Sullivan also won- 
dered if a National League game broadcast on a Sunday afternoon would 
affect the attendance at a Friday night American League game in Boston. 
An average of 10 million homes were reached by National League TV 
every Sunday, and the 1958 Baltimore-New York game drew a record 
TV audience of 15 million homes as well as a gate attendance of over 
64,000 persons. The 1958 average National League attendance was 42,000 
persons per game, with Los Angeles averaging over 74,000 persons at all 
home games. Exhibit 6 gives each team's average annual attendance for 
a recent season. The average price of a National League ticket was $4. 

The American Football League also faced competition from American 
and National League baseball games during September and October. 
Many of these games were to be telecast and could draw attendance away 
from scheduled football games. 

Finally, Mr. Sullivan believed that this new football league would be 
in competition with local college and university football games all across 
the country. Many persons felt that, "There is nothing like returning to 
the old alma mater on a crisp fall afternoon for a rousing good Saturday 
game of ball," a sentiment expressed by several of Mr. Sullivan's business 
associates. 

Because of these competitive sports activities Mr. Sullivan had sched- 
uled all the Patriots' home games on Friday night in order to avoid con- 



344 The Boston Patriots 

flict with other sports activities. He was confident that the public would 
accept night football with the same enthusiasm which night baseball 
had received in Boston. 



Required 

1. Should Mr. Dolan purchase the common stock of the Patriots offered him 
by his broker? 

2. What accounting policies would you recommend that Mr. McKeever estab- 
lish for the preparation of financial statements of a publicly owned profes- 
sional football team? 

3. Would you support the argument of the CPA, the Patriots' management, or 
the legal counselor concerning organization expense? If you would support 
none of these arguments, what would be your recommendation relative to 
the organization expense? 

4. Prepare financial statements for the 1960 season assuming that total cur- 
rent liabilities as of December 31, 1960, were $11,000. Calculate the 
balance in the cash account on December 31, 1960, based on information 
in the case and on the income assumptions you made. 

5. Should the same financial statements be used both in assessing the Patriots 
as an investment opportunity and in reporting to the Patriot's shareholders 
at the end of the season? 

6. Should the Patriots choose a fiscal year ending on a date other than 
December 31? 



EXHIBIT 1 


Composition of the American and National 


UiKLlJyL/l JL X 


tall League 


Football Leagues 






A. American Foott 












City Population 


City 


Name 


Stadium 


Capacity 


(thousands)* 


Eastern Division 








Boston 


Patriots 


Boston University Field 


25,000t 


3,074.4 


Buffalo 


Bills 


Municipal Stadium 


31,000 


1,338.3 


Houston 


Oilers 


Jepperson Field 


38,000 


1,212.0 


New YorkJ 


Titans 


Polo Grounds 


55,000 


10,628.4 


Western Division 








Dallas J 


Texans 


Cotton Bowl 


78,000 


1,066.4 


Denver 


Br ones 


Bears Stadium 


37,000 


895.2 


Los Angeles 


Chargers 


Coliseum 


102,000 


6,624.2 


Oakland* 


Raiders 


Kezar Stadium 


58,000 


2,731.2 


B. National Football League 
















City Population 


City 


Name 


Stadium 


Capacity 


(thousands)* 


Eastern Division 








Chicagofl 


Cards 




47,000 


6,674.5 


Cleveland 


Browns 


Municipal Stadium 


78,000 


1,785.5 


New York 


Giants 


Yankee Stadium 


67,000 


10,628.4 


Philadelphia 


Eagles 


Franklin Field 


41,000 


4,439.1 


Pittsburgh 


Steelers 


Forbes Field 


35,000 


2,381.5 


Washington 


Redskins 


Griffith Stadium 


37,000 


2,034.3 


Western Division § 








Baltimore 


Colts 


Memorial Stadium 


58,000 


1,748.0 


Chicago 


Bears 


Wrigley Field 


49,000 


6,674.5 


Detroit 


Lions 


Briggs Stadium 


53,000 


3,963.5 


Green Bay 


Packers 


City Stadium 


32,000 


310.6 


Los Angeles 


Rams 


Memorial Coliseum 


102,000 


6,624.2 


San Francisco 49'ers 


Kezar Stadium 


58,000 


2,731.2 



* Population of the greater metropolitan area, 1960. 
flncludes 8,000 seats to be added prior to start of the 1960 season. 
JThe National Football League also has teams in these cities. 
tfThe Chicago franchise has been transferred to St. Louis during 1960. 
SDallas, Texas, has been granted a National League franchise which becomes effec- 
tive for the 1960 season. 



345 



EXHIBIT 2 



Excerpt from Prospectus Offering 
Patriots' Common Stock 



PROSPECTUS 

120,000 Shares 

AMERICAN LEAGUE 
PROFESSIONAL FOOTBALL TEAM OF BOSTON, INC 



COMMON STOCK 

(SI Par Value, non-voting) 

Price S5.00 Per Share 

THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECUR- 
ITIES AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON 
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO 
THE CONTRARY IS A CRIMINAL OFFENSE. 

THESE ARE SPECULATIVE SECURITIES 
(See "Introductory Statement" P. 3) 





Price to 
Public (1) 


Undericriting 

Discounts and 

Commissions (2) 


Proceeds to the 
Company (3) 


Per Share 

Total 


S 5.00 
$600,000 


S .50 
560,000 


S 4.50 
$540,000 







(1) This price has been determined by negotiations between the Company and the Underwriters. 

(2) The Company has agreed to indemnify the Underwriters against certain liabilities, including certain liabilities 

under the Securities Act of 1933. 

(3) Before deducting expenses, estimated at 521,000, incurred by the Company in connection with this offering. 

The shares of Common Stock are being offered by the Underwriters named below, subject to 
prior sale and when, as and if delivered to and accepted by the Underwriters, subject to approval 
of their counsel as to legal matters and to certain other conditions. It is expected that delivery of certifi- 
cates for shares of Common Stock will be made at the office of Old Colony Trust Company, Boston, 
Massachusetts on or about July 26, 1960. 



Estabrook &" Co. 

Tucker, Anthony & R. L. Day 



F. S. Moseley & Co. 



White, Weld & Co. 

Incorporated 

The date of this Prospectus is July 18, 1960 



346 



EXHIBIT 3 



Balance Sheet, June 30, 1960 



Statement of Assets and Unrecovered Promotional Costs 



Current Assets : 
Cash 

Stock subscriptions receivable— due June 1, 1960 
Salary advances 
Deposit receivable 

Total current assets 



$ 97,546.78 

55,000.00 

10,507.77 

425.00 



$163,479.55 



Other Assets and Unrecovered Promotional Costs : 

Leasehold improvements— at cost office and stadium 

Furniture and fixtures— at cost 

League franchise fee 

Unrecovered promotional costs: 

General administrative expenses $63,405.05 

Bonuses paid to players 27,975.00 

Other expenses 25,234.86 

Prepaid expenses 



4,589.00 

4,054.90 

25,000.00 



116,614.91 
3,692.77 



Total other assets and unrecovered promotional costs 
Total assets and unrecovered promotional costs 



153,951.58 
$317,431.13 



Statement of Liabilities and Capital Shares 



Current Liabilities : 
Accounts payable 
Accrued liabilities 
Other current liabilities 



$ 1,000.00 

576.14 

1,959.99 



Total current liabilities 



$ 3,536.13 



Deferred income— advance sale of tickets 
Total liabilities 

Capital Stock: 

Nonvoting common stock ($1 par value) 

150,000 shares authorized 

No. shares outstanding 
Class A common stock ($1 par value) 

100,000 shares authorized 

No. shares issued for cash (78,000) 

No. shares subscribed to and to be issued 

June 1, 1960 (22,000) 

Total capital stock 

Total liabilities and capital stock 



None 

$195,000 
55,000 



63,895.00 
$ 67,431.13 



250,000.00 
$317,431.13 



347 



EXHIBIT 4 



Statement of Receipts and Disbursements and 

Anticipated Operating Expenses for the 

Boston Patriots 



(i) 

Cumulative State- 
ment of Cash 
Receipts to Dis- 
bursements From 
Inception to 
June 30, 1960 

Receipts 

Sale of 78,000 shares of Class A floating 

stock $195,000.00 

Advance sale of tickets 63,895.00 

Total Receipts $258,895.00 

Disbursements : 

Airline deposit $ 425.00 

League franchise fee $ 25,000.00 

Office construction payments 2,850.00 

Stadium construction payments 1,739.00 

Furniture and fixtures 4,055.00 

Bonuses to players 27,975.00 

Salary advance to players 10,508.00 

Annual league membership fee 1,000.00 

Salaries of directors and officers— to Mr. 

Sullivan 15,000.00 

Other Salaries and wages— office and 

coaching 31,208.60 

Office rent 3,276.00 

Telephone and telegraph 3,304.66 

Hotel, travel, functions and scouting 

expenses 12,277.80 

Professional services— legal and accounting . 3,750.00 

Advertising and promotional expenses 9,795.17 

Office supplies and expense 5,798.70 

Insurance performance bond 2,000.00 

Payroll tax expense 686.70 

Player's uniforms 698.59 

Total Disbursements to June 30, 1960 . $161,348.22 

Cash Balance as of June 30, 1960 .... $ 97,546.78 

Mr. McKeever's annual salary 

Mr. Saban's annual sallary 

Player's salaries 

Automobile expense 

Trust account under B.U. indemnity agree- 
ment 

Liability insurance 

Surgical and Hospitalization Insurance .... 

Annual stadium maintenance expense 

Training Equipment 

Food and lodging at training camp 

Travel Expenses while team is on the road . . 
Total Anticipated Annual Disburse- 
ments 



(2) 
Total Expenses 
Anticipated for 
First Annual 
Season (Incep- 
tion to Dec. 31, 
1960) 



(3) 
Recurring Annual 
Expenses Antici- 
pated in Seasons 
Subsequent to the 
1960 Season 



$ 425.00 


-0- 


25,000.00 


-0- 


4,600.00 


-0- 


200,000.00 


-0- 


4,055.00 


-0- 


27,975.00 


* 


10,508.00 


11,000.00 


1,000.00 


1,000.00 


25,000.00 


20,000.00 


88,500.00 


88,500.00 


7,776.00 


9,000.00 


7,600.00 


7,600.00 


22,300.00 


22,300.00 


6,750.00 


7,000.00 


13,000.00 


13,000.00 


6,300.00 


5,300.00 


2,000.00 


-0- 


12,000.00 


12,000.00 


13,900.00 


7,400.00 


20,000.00 


20,000.00 


16,667.00 


16,667.00 


289,080.00 


297,000.00 


751.00 


751.00 


50,000.00 


* 


22,000.00 


* 


25,000.00 


25,000.00 


25,000.00 


25,000.00 


8,300.00 


3,800.00 


32,800.00 


32,800.00 


57,500.00 


57,500.00 


$1,025,787.00 


$682,618.00 



♦Uncertain or variable over a period of time (see text). 



348 









1960 Boston Patriots' Season Schedule with 




EXHIBIT 5 




Indication of Competitiv 
Sports Activities 


e Local Area 




















Competitive Football Activity 










Anticipated During Indicated 


Friday 


Date 
September 9 


Denver 


Team 
(at Boston)! 


Weekend* f 




Sunday 


September 18 


New York 


(at New York) 




Friday 


September 23 


Buffalo 


(at Boston) 


Harvard vs. Holy Cross-$4.00H 


Sunday 


October 9 


Los Angeles (at Los Angeles) 




Sunday 


October 16 


Oakland 


(at Oakland) 




Sunday 


October 23 


Denver 


(at Denver) 




Friday 


October 28 


Los Angeles (at Boston) 


Harvard vs. Pennsylvania— $4.00 










and B.U. vs. Univ. of Mass§ 


Friday 


November 4 


Oakland 


(at Boston) 




Friday 


November 11 


New York 


(at Boston) 


Harvard vs. Brown— $4.00 

and B.U. vs. Boston College— 
$3.00 


Friday 


November 18 


Dallas 


(at Boston) 


Harvard vs. Yale-$6.00 


Friday 


November 25 


Houston 


(at Boston) 




Sunday 


December 4 


Buffalo 


(at Buffalo) 




Sunday 


December 11 


Dallas 


(at Dallas) 






Sunday 


December 18 


Houston 


(at Houston) 





*No National League Football Games will be played within 200 miles of the home team's 
city during the indicated weekend, but televised National League ball games will be broad- 
cast on Sunday of each of the above indicated weekends in the home city. A bill sponsored 
by Senator Kefauver is currently under consideration and if passed would eliminate this 
competitive telecasting. 

tin addition to the indicated football games, professional baseball games will be played 
during all weekends until the middle of October. 

JA11 home games are played on Friday nights at 8:00 p.m. at Boston University Field. 

^Harvard University has averaged 18,033 attendance per game during the past five 
years, with a low in 1959 of 16,240 and a high of 22,454 in 1956. Approximately 20% of this 
attendance could be accounted for by free student admission and by complimentary passes. 
Harvard's record was 18 wins, 23 losses, and 1 tie during this 5-year period. The average 
ticket price is $4, but all tickets to the popular Yale game sell for $6. 

§Boston University (B.U.) has averaged 12,000 attendance per game during the past five 
years, with a low in 1955 of 10,000 and a high of 14,200 in 1959. Approximately 70% of this 
attendance is "paid" attendance. B.U.'s record was 17 wins, 23 losses, and 2 ties during 
this 5-year period. Sideline tickets sell at $3 each. 



349 



EXHIBIT 6 



National Football League Home Attendance for a 
Recent Season 





Home Games 


Total 


Avg./Game 


Capacity 


Los Angeles 


6 


445,776 


74,296 


101,000 


San Francisco 


6 


337,980 


56,330 


60,000 


Detroit 


6 


334,458 


55,743 


53,000 


Cleveland 


6 


324,165 


54,028 


78,000 


New York 


6 


290,667 


48,443 


67,000 


Baltimore 


6 


279,888 


46,648 


53,000 


Chicago Bears 


6 


269,114 


44,852 


49,000 


Pittsburgh 


6 


168,957 


28,160 


35,000 


Green Bay 


6 


161,103 


26,851 


32,000 


Washington 


6 


157,997 


26,333 


37,000 


Philadelphia 


6 


129,654 


21,609 


41,000 


Chicago Cubs 


5 


126,272 


25,254 


47,000 


Source: National Football League Record and Rules Manual and Mr. Joseph T. 


Labrum, 



Assistant to the Commissioner, The National Football League. 



The Boston Yanks Attendance Record for Selected Years 



1945 Season 
Games and Score 



Yanks 


28 


Steelers 


7 


Yanks 


28 


Redskins 


20 


Yanks* 


13 


Giants 


13 


Yanks 


14 


Packers 


38 


Yanks 


10 


Steelers 


6 


Yanks 


9 


Lions 


10 


Yanks 


7 


Redskins 


34 


Yanks 





Packers 


28 


Yanks 


7 


Rams 


20 


Yanks 


7 


Eagles 


35 


1948 Season 






Games and Score 




Yanks 





Packers 


31 


Yanks 


7 


Giants 


27 


Yanks 


14 


Steelers 


23 


Yanks 


17 


Lions 


14 


Yanks 


13 


Steelers 


7 


Yanks 


27 


Cardinals 


49 


Yanks 


21 


Redskins 


59 


Yanks 


7 


Redskins 


23 


Yanks 





Eagles 


45 


Yanks 


17 


Bears 


51 


Yanks 


14 


Giants 


28 


Yanks 


37 


Eagles 


14 


♦Yanks home game played i 


Source: Boston Globe S 


ports 



Weather 


Attendance 


Site 


Good 


27,502 


Boston 


Rain 


21,333 


Boston 


Rain 


30,988 


New York 


Rain 


17,877 


Milwaukee 


Good 


21,596 


Pittsburgh 


Snow 


12,582 


Boston 


Good 


33,418 


Washington 


Rain 


31,923 


Boston 


Cold 


17,315 


Cleveland 


Good 


24,622 


Philadelphia 


Attendance 


Site 


Date 


15,443 


Boston 


September 17 


7,428 


Boston 


September 23 


26,216 


Pittsburgh 


October 3 


22,609 


Detroit 


October 9 


7,208 


Boston 


October 17 


23,423 


Chicago 


October 24 


29,789 


Washington 


October 31 


13,659 


Boston 


November 7 


22,958 


Philadelphia 


November 14 


18,048 


Boston 


November 21 


19,636 


New York 


November 28 


9,658 


Boston 


December 5 



350 



CASE 46 



Adamian 

Metallurgical Corporation 



i 



n October 1958, Mr. Peter Adamian, president of 
Adamian Metallurgical Corporation, was engaged 
in a re-examination of the methods used in setting prices for the services 
sold by his company. Adamian Metallurgical Corporation ( AMC ) was a 
commercial heat-treating company located in Birmingham, Alabama. The 
company offered a variety of heat-treating services, such as carburizing, 
hardening, tempering, and brazing, to local metalworking companies and 
machine shops. 

Mr. Adamian had founded AMC in 1946 after being released from 
the Army. He had taken a degree in metallurgy in 1934 and had worked 
for several years for a commercial heat-treating company before the war. 
Between 1946 and 1954, AMC had experienced a steady growth in sales 
volume and profits; after 1954, sales volume had been relatively stable. 
A balance sheet as of July 31, 1958, and income and surplus statements 
for the fiscal year then ended are presented in Exhibits 1, 2, and 3. Con- 
densed income statements for the years 1949-1957 are shown in Exhibit 4. 

HISTORY OF COMMERCIAL HEAT-TREATING 

Heat-treating is a process whereby the physical properties of a metal 
may be changed by subjecting it to heat. Typically, heat-treating is done 
for one of two purposes: (1) Hardening the surface of the metal to im- 

351 



352 Adamian Metallurgical Corporation 

prove its wearing qualities, or (2) annealing the metal to improve its 
further workability by removing molecular stresses and strains created by 
prior metal-forming operations. Another heat-treating operation called 
brazing is a process whereby two pieces of metal are joined together by 
applying a compound (analogous to glue) to the two pieces and heating 
them until the compound "flows" to join the two surfaces. AMC was 
engaged primarily in the hardening and brazing processes. 

Prior to World War II, steel was hardened principally by inducing car- 
bon into the surface. This "carburizing" process was one of the earliest 
heat-treating methods and was a relatively simple process: The parts 
to be hardened were covered with a carburizing compound, put in a 
furnace for several hours and removed when enough of the carbon had 
been driven by the heat into the steel to harden it. With the development 
of specialty steels during the war, and the improvement in cutting tools 
and other technological advances, a wider variety of heat-treating 
methods was necessary. In 1958, AMC had six different furnaces and 
offered a fairly complete range of hardening and brazing capabilities. 

1. The box furnace was a fire-brick, box-shaped gas furnace used for 
carburizing. 

2. The hardening furnace and tempering furnaces were continuous- 
operation gas furnaces. Trays of metal parts were pushed into one 
end of the hardening furnace and, after maximum hardness was 
attained, pushed out the other end and quenched. The parts were 
then pushed through the tempering furnace where, at somewhat 
lower temperatures, the brittleness of the metal caused by the 
hardening operation was modified. The final result was a hardened 
part with good tensile strength. These two furnaces were always 
used together, and were regarded as a single process. One hour of 
furnace time in this process was defined as one hour in each furnace. 

3. The salt pot furnace was another hardening process in which the 
furnace was in continuous operation. Parts to be hardened were im- 
mersed in a hot brine solution until the desired toughening result 
was achieved. 

4. The Hayes furnace was a small, versatile, continuous electrical 
furnace that would do both hardening and brazing operations. 

5. The brazing furnace was an electrical, continuous furnace used ex- 
clusively for brazing operations. 

6. The induction furnace was another hardening furnace using a rela- 
tively new specialized process on the batch method. This furnace 
had been acquired in 1956, and was rapidly gaining acceptance. 
Operations of this furnace were not profitable during 1957, but Mr. 
Adamian felt that after a "shakedown period," the induction furnace 
would be a profitable addition to his line. 



Adamian Metallurgical Corporation 353 

Each of these furnaces was relatively independent of the other furnaces 
in its operation, that is, a part processed in one furnace would not nor- 
mally go through another furnace. The main exception to this procedure 
was that occasionally a part would be carburized in the box furnace 
prior to hardening in another furnace. 



COMPETITION AND PRICING PROCEDURES 

AMC was one of four commercial heat-treaters operating in Birming- 
ham. One of these companies was several times the size of AMC, the 
other two were slightly smaller than AMC. 

An indirect source of competition was manufacturers of metal products 
who did heat-treating of their own products in their own plants. Com- 
monly, this was done whenever the volume of work was large enough to 
support installation of a furnace, thus limiting commercial heat-treaters 
to essentially small-volume customers. Large manufacturers occasionally 
used a commercial heat-treater when the manufacturer's volume was too 
great for his own furnace capacity, or when a specialized type of process 
was required which the manufacturer's equipment could not handle. 

In 1958, AMC's volume of $165,041 was the result of 10,414 invoices 
representing individual customer orders. The average size of an order 
was thus $15.85. Mr. Adamian pointed out that the minimum price for 
any order was $2.50, and he estimated that 80 per cent of the total orders 
were for small dollar amounts between $2.50 and $6.00. The remaining 
orders included some big jobs running up to $300, thus raising the average 
order size to $15.85. 

Typically, Mr. Adamian said, a customer would bring in parts to be 
processed and expect to pick up the completed work within three days. 
The Hayes and induction furnaces were usually operated on a two-shift 
basis, and the other furnaces were operated twenty-four hours a day. The 
plant worked a five-day week. On a rush basis, jobs could be handled 
in one day and many jobs were completed in two days. Actual processing 
time for a job varied as a result of the technical specifications to be met; 
a typical small order being processed through the hardening and temper- 
ing furnace might require one "furnace hour." Small orders processed 
in one of the continuous furnaces did not require the full capacity of a 
furnace at any time. When technical specifications permitted, several 
small orders might be in one furnace at the same time. 

Because many of his customers were job-order machine shops and small 
metalworking companies, Mr. Adamian explained that it was almost im- 
possible for AMC to schedule its work load even one day in advance. 
AMC had several hundred customers, each with a small volume of heat- 
treating requirements, and the customers could not predict when they 



354 Adamian Metallurgical Corporation 

would need work done. Mr. Adamian stressed the importance of customer 
service in maintaining his business. On an initial order, a customer might 
ask for a bid before placing his order with AMC. If the price on that order 
was acceptable, and the quality and service delivered were good, Mr. 
Adamian said the customer might become a steady source of business 
with no future questions about price on later orders. 

One of the problems in preparing bids for new customers or in pricing 
the jobs for established customers was that, when Mr. Adamian was out 
of the shop, the pricing might be done by either the plant superintendent 
or the shop foreman. Since these two men, as well as Mr. Adamian, had 
slightly different methods of estimating costs, the price that one man might 
quote for a job frequently varied from the price quoted for an identical 
job by one of the other officials. Mr. Adamian pointed out that this oc- 
casionally resulted in a request from a customer for clarification on ex- 
actly what the price was for a given type of work. 

With these operating and customer characteristics in the heat-treating 
industry, Mr. Adamian said it was very difficult to find an equitable basis 
for pricing the jobs of steady customers and for preparing bids for 
prospective orders. One of the primary causes of difficulty was that before 
World War II, the price for the carburizing process had been fairly well 
stabilized at $.08 per pound by all the heat-treating companies in Birming- 
ham. After the war, prices had risen with inflation to about $.15 per 
pound, and this was the price that customers had come to expect as the 
standard price for heat-treating (hardening) service. The reason the $.15 
price was unfortunate, Mr. Adamian said, was that customers expected 
that this price would cover the heat-treating service they required, re- 
gardless of its technical complexity. With the growing variety of processes 
and increasingly rigid specifications as a result of improved technology, 
this price was too low to support profitable operations. Nevertheless, Mr. 
Adamian said, there was great customer resistance to prices quoted above 
$.15 per pound for hardening as done in the hardening and tempering, 
Hayes, or salt pot furnaces. Customers had no such preconceived ideas 
about a proper price for the brazing and induction furnaces, so Mr. 
Adamian was able to charge a price which he considered adequate to 
yield a profit. 

One of the solutions to the pricing problem considered by Mr. Adamian 
was to quote prices on a "per part" basis. Mr. Adamian had found that 
his customers tended to think about their production costs as being "so 
much per part," and were receptive to having their heat-treating service 
quoted on that basis. Mr. Adamian saw an advantage in quoting prices 
this way in that he was able to quote a per-part price that was higher 
on a "per pound" basis than the $.15 considered as normal. However, he 
still had the problem of trying to determine what the per-part price 
should be. 



Adamian Metallurgical Corporation 355 

During fiscal year 1958, AMC suffered its first loss in nine years. Mr. 
Adamian attributed this loss to the recession during that period. "We were 
able to maintain our volume pretty well, but only by shaving prices to a 
point apparently below break-even," he said. Recognizing the growing 
seriousness of his pricing problem in April 1958, Mr. Adamian called in 
Mr. Richard Showalter, a local management consultant, for assistance. 

THE CONSULTANT'S ANALYSIS 

In trying to devise a system for cost-based bidding and pricing, Mr. 
Showalter reasoned that essentially the service that AMC was selling 
was furnace time. Mr. Adamian said it was easy to make reliable predic- 
tions of furnace time for any job because the time required was deter- 
mined by the technical specifications of the job. Accordingly, Mr. 
Showalter decided to distribute all costs to the furnaces in order to arrive 
at a total cost per furnace, which could then be used to determine break- 
even prices for each type of furnace. The results of this analysis are 
shown in Exhibit 5. 

Mr. Showalter decided to use income and expense data for the calendar 
year 1957, because he wanted to use the most recent information, and 
final figures for fiscal year 1958 would not be available for several months. 
His first step was to obtain sales revenue for each furnace. This data was 
readily available because all sales invoices were classfiied according to 
the furnace in which the work had been done. For those few jobs (less 
than 10 per cent of the total) which had gone through more than one 
furnace, revenue was allocated between furnaces on a proportional basis 
reflecting historical "cents-per-pound" prices for each furnace. 

In distributing costs by furnace, Mr. Showalter knew that many ex- 
pense items could not be identified with a specific furnace and would 
have to be allocated on some reasonable basis. He decided to divide non- 
assignable costs into three categories: shop overhead, selling expenses, 
and administrative expenses. In Exhibit 6 the components of each cate- 
gory in Exhibit 5 are related back to the listing of operating expenses 
shown in Exhibit 2. 

Also shown in Exhibit 6 is Mr. Sho waiter's evaluation of each expense 
item in terms of its variability with changes in the rate of production. He 
found that the most variable expense was supplies used in the furnaces 
(salt, brazing paste, carburizing compound, and so on) which varied 
almost directly with the volume of work procesed. Expenses for repairs 
and for gas were not directly variable because all the furnaces were 
usually run every day, although the harder use involved when the fur- 
naces were running full probably did increase gas consumption and 
necessitate earlier repair work than did running the furnaces partly filled 
or empty. Similarly, shop direct labor was not completely variable since 



356 Adamian Metallurgical Corporation 

the same number of attendants were required whether the furnace was 
completely or partially filled. Further, because customer requirements for 
processing could not be accurately predicted even one day in advance, 
AMC usually had the full work force (about fourteen men) report each 
day and the men worked more or less hard depending upon how much 
work was available. Commenting on this problem, Mr. Adamian had said, 
"We don't lay men off as much as we should/' 

Mr. Showalter found that some expenses, such as consulting fees, 
entertainment, advertising, and so on, were neither fixed nor variable by 
the nature of the operations. He classified these expenses as controllable 
by management decision. 

In preparing his cost distribution, Mr. Showalter did not allocate any 
cost to the sand-blasting operation. This operation was a method used to 
improve the surface appearance of parts that had been treated in the 
hardening and tempering furnaces or the salt pot furnace. Because the 
cost of this operation was small, it was usually not included specifically 
as a factor when bids were prepared. Therefore the loss shown in Exhibit 
4 was due to an underallocation of revenue to this operation, and to 
adjust for it the loss was split between the two furnaces using sand 
blasting. Similarly, the box furnace was, in Mr. Adamian's words, "a 
necessary evil," for which a detailed cost analysis was not necessary. 
Since the assignable costs and revenue for this furnace were small, Mr. 
Showalter ignored it in his allocation of selling expenses and administra- 
tive expenses. 

In order to determine "break-even" revenue rates, Mr. Showalter 
needed some estimate of the number of hours that each furnace would be 
utilized during the year. No actual data on the utilization rate were avail- 
able. As a practical matter, during the five-day work week the furnaces 
were never allowed to cool completely, although the Hayes and induction 
furnaces were cut back to a stand-by temperature between midnight and 
8 a.m. Most of the other time, all the furnaces were "active" to a greater 
or lesser extent. Depending on how compatible the different jobs were, 
a furnace might run completely full or might contain only one job being 
processed to unusual specifications. 

Mr. Showalter asked Mr. Adamian to estimate the average number of 
equivalent hours each day that each furnace would be completely full. 
Thus, two hours during which the furnace was only 50 per cent full were 
counted as one equivalent revenue hour. Mr. Adamian's estimates of 
average equivalent revenue hours per day are shown on Exhibit 5. 

THE BEAUREGARD TOOL WORKS JOB 

Mr. Adamian had still not resolved his pricing policy by October 1958, 
when he was contacted by Mr. A. L. Hickory, president of Beauregard 



Adamian Metallurgical Corporation 357 

Tool Works. Mr. Hickory's company operated four automatic screw ma- 
chines on a job-order basis in a barn behind Mr. Hickory's home. Mr. 
Hickory explained that he was dissatisfied with the heat-treating service 
he had been receiving from one of AMC's competitors, and would like 
Mr. Adamian to bid on a job that Beauregard was working on. The job 
involved 1,000 small parts, weighing in total 40 pounds. Mr. Adamian's 
usual practice was to quote a price immediately, but in this case, realizing 
that the job might develop a lot of repeat business, he asked Mr. Hickory 
to give him a day or so to work up a good price on this job that could 
be used as a pattern for future prices on similar jobs for Beauregard. 

Considering the Beauregard job after Mr. Hickory left, Mr. Adamian 
knew that the "standard" bid should be $6, based on 40 pounds at $.15 
per pound. He knew it would take about an hour to run the job through 
the hardening and tempering furnaces, indicating a cost of $7.55, to 
which some allowance for profit should be added. However, this job 
would probably require only 60 per cent of the furnace capacity while 
going through, so that if the remaining capacity could be sold, a lower 
price might be justifiable. Finally, Mr. Adamian recognized this job as a 
good opportunity to quote a price of one cent per part, thus getting $10 
of revenue if the bid were accepted. 

Required 

1. What price should Mr. Adamian bid on the Beauregard job? 

2. For the purpose of making bids and setting prices in the future, should Mr. 
Adamian figure his costs on a per pound, per part, or per furnace-hour 
basis, or on some other basis, if at all? 



EXHIBIT 1 



Balance Sheet, July 31, 1958 



Assets 



Current Assets: 

Cash 

Accounts receivable 

Notes receivable 

Vork- in- process inventory 

Supplies inventory 

Investments: 

Fixed Assets: Cost Reserve 

Equipment $50,504.27 $25,510.03 

Office equipment 1,262.29 548.79 

Trucks 8,836.46 1,627.14 

Totals $60,603.02 $27,685.96 

Prepaid Expenses: 

Other Assets— Treasury stock (34 shares) . 
Total Assets 



$ 164.34 

28,687.04 

6,752.85 

340.00 



Net Value 

$24,994.24 

713.50 

7,209.32 



$37,999.92 
9,576.00 



32,917.06 
1,760.44 



$85,653.42 



Liabilities and Net Worth 

Current Liabilities: 

Accounts payable 

Notes payable 

Accrued expenses 

Long-term Liabilities: 

Notes payable 

Total liabilities 

Net Worth: 

Capital stock (250 shares issued) 

Surplus (Exhibit 3) 

Total net worth 

Total liabilities and net worth . 



3,139.20 
8,381.90 
4,404.92 $15,926.02 



$25,000.00 
36,045.53 



8,681.87 
$24,607.89 



61,045.53 
$85 653.42 



358 



,.L 



EXHIBIT 2 



Income and Expense Statement for the Fiscal Year 
EndedJuly 31, 1958 



Amounts 
Income: 

General sales $165,041.52 

Service sales 20,407.02 

Total sales $185,448.54 

Deduct: Sales discount $ 1,067.78 

Breakage of customer parts . . . 1,803.01 2,870.79 

$182,577.75 

Deduct: Service purchases 11,405.39 

Gross income $171,172.36 

Operating Expense: 

Plant expense: Shop labor $66,845.58 

Supplies 10,006.21 

Gas 6,140.30 

Power & light 10,521.02 

Water 389.75 

Rent 6,099.96 

Laundry 684.07 

Truck expense 5,609.35 

Administrative 

expense: Exec, salary $11,500.00 

Office salaries 8,819.94 

Office supplies 1,760.42 

Telephone & telegraph 1,791.60 

Consulting fees 785.00 

Audit & tax service 187.50 

Travel & entertainment .... 6,508.51 

Sales salary 7,833.27 

Sales expense 1,747.06 

General expense: Property taxes $ 1,155.59 

Payroll taxes 1,769.38 

Insurance 4,340.66 

Repairs 7,097.17 

Depreciation 6,954.72 

Interest expense 525.52 

Advertising 5,044.72 

Bank charges 11.20 

Miscellaneous 1,991.98 



Per 


Cent 


of Sales 




89.00% 




11.00 




100.00% 


0.58% 




0.97 


1.55 




98.45% 




6.15 




92.30% 





36.05% 






5.40 






3.31 






5.67 






0.21 






3.29 






0.37 




$106,296.24 


3.02 

6.20% 

4.76 

0.95 

0.97 

0.42 

0.10 

3.51 

4.22 


57.32% 


40,933.30 


0.94 

0.62% 

0.95 

2.34 

3.83 

3.75 

0.28 

2.72 

0.01 


22.07 


28,890.94 


1.08 


15.58 


$176,120.48 




94.97% 


$ (4,948.12) 




(2.67%) 



Total operating expense 

Net operating loss 

Other income: Subleasing part of building ... $ 2,606.37 1.41% 

Other expense: Accts. receivable charged off 361.33 2,245.04 .91 1.22 

Net loss $ (2,703.08) (1.45%) 



359 



EXHIBIT 3 



Statement of Earned Surplus as of July 31, 1958 



Balance, August 1, 1957 

Deductions: 

Key man insurance $1,852.00 

Health and accident insurance 390.45 

Cash dividend 2,160.00 

Deduct: Net loss for year (Exhibit 2) 

Balance, July 31, 1958 (to Exhibit 1) 



$43,151.06 



4,402.45 
$38,748.61 

2,703.08 
$36,045.53 



EXHIBIT 4 


Condensed Inc 


:ome Statements, 1949 

Expenses 
Administrative General 


-1957 


Fiscal Year 


c 


sales Operating 


Net Operating In- 
come Before Taxes 


1957 


$180,441 $103,569 


$37,874 


$29,874 


$ 9,523 


1956 


165,628 94,543 


30,688 


30,854 


9,543 


1955 


130,078 79,867 


25,291 


23,748 


1,172 


1954 


173,063 91,846 


34,999 


29,825 


16,393* 


1953 


156,082 89,112 


27,147 


22,671 


17,152 


1952 


Not available 








1951 


99,908 56,839 


10,744 


15,359 


16,966 


1950 


47,546 31,195 


5,983 


10,212 


156 


1949 




54,787 38,738 


6,580 


11,450 


(1,981) 



♦Dividends of $1,250 were paid in February 1954. 



360 



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EXHIBIT 6 



Relationship Between Income Statement and 
Consultant's Cost Analysis 



Cost Category Used 
in Exhibit 5 

Assignable: 



Shop Overhead: 



Selling Expense: 



Administrative 
Expense: 





Cost Variability 


Operating Expenses Listed in Exhibit 2 


Rating 


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Partly variable 


Supplies (approximately 75% of total 




supplies) 


Variable 


Gas 


Partly variable 


Power and light 


Partly variable 


Repairs (approximately 50% of total 




repairs) 


Partly variable 


Depreciation on furnaces 


Fixed 


Shop labor (supervision) 


Fixed 


Supplies (remainder not directly 




assignable) 


Fixed 


Water 


Fixed 


Laundry 


Fixed 


Insurance on building contents 


Fixed 


Repairs (remainder not directly 




assignable) 


Fixed 


Miscellaneous 


Fixed 


Breakage of customer parts 


Unpredictable 


Shop labor (truck driver) 


Fixed 


Truck operating expenses 


Partly variable 


Travel and entertainment 


Controllable 


Sales salary 


Fixed 


Sales expense 


Fixed 


Insurance on car and truck 


Fixed 


Depreciation on car and truck 


Fixed 


Advertising 


Controllable 


Rent 


Fixed 


Executive salary 


Fixed 


Office salaries 


Fixed 


Office supplies 


Fixed 


Telephone and telegraph 


Fixed 


Consulting fees 


Controllable 


Audit and tax service 


Fixed 


Taxes— property 


Fixed 


Insurance— business interruption 


Fixed 


Depreciation on office equipment 


Fixed 


Interest expense 


Fixed 


Bank charges 


Fixed 


Key man insurance (charged directly 




to surplus) 


Fixed 



Note : Payroll taxes, which were directly variable with wages and salaries 
paid, were assigned to each of the four categories on the basis of a percentage of 
wages and salaries expense. 



362 



CASE 47 



Microflex., Inc. 



i 



n February 1960, Mr. Donald Sears, the recently 
elected president of Microflex, Inc., decided to 
seek outside aid in solving the company's problem of rapidly declining 
profits. Microflex was located in Beverly Hills, California. After making 
some inquiries among his friends in the business community, Mr. Sears 
decided to contact Mr. S. T. Glickman, a Professor of Business Adminis- 
tration at a near-by campus of the University of California. Mr. Sears' 
letter to Mr. Glickman is quoted in part below. 

Dear Professor Glickman: 

My friends at the First Security National Bank have suggested that 
you might be helpful to us in connection with cost accounting and pricing 
of our business with government agencies and commercial prime con- 
tractors under government contracts in the aircraft, missile, rocket engine, 
and nuclear fields. We manufacture flexible metal tube assemblies for a 
variety of applications in these fields. 

We are, with increasing frequency, being asked to submit price break- 
downs with our quotations. I assume that this practice will increase. (As 
a taxpayer, I applaud it.) We have for some years successfully competed, 
using what the trade calls "ball park" estimates. This method is now losing 
us orders in highly competitive situations. It also does not satisfy my 
banker's background as a proper basis on which to do our business. 
Finally, I am sure that as the profit margins of the larger companies con- 
tinue to be squeezed in this area, we will be losing more and more busi- 
ness on very fine margins. 

We are repricing standard examples of our line on a formula based in 
part on experience given to us by our sales representative. We are finding 
that a single formula shows wide discrepancies between the items with 

363 



364 Microflex, Inc. 

large labor content and large material content (and we include in mate- 
rial, parts machined for us outside). 

« « 

Sincerely yours, 

Microflex, Inc. 

Donald K. Sears, President 

Mr. Glickman responded to Mr. Sears' inquiry, and agreed to visit the 
Beverly Hills plant in order to learn more about the problem. 



HISTORY OF MICROFLEX, INC. 

Microflex, Inc., was founded in 1947 by Mr. K. T. Duncan, an engineer 
and an inventor who had recognized a need for high-quality flexible tub- 
ing components in aircraft manufacturing. Although the flexible metal 
tube (FMT) developed by Mr. Duncan was not a new product, it did 
incorporate certain technical improvements which he thought made his 
product superior to those offered by competitors. An illustration of several 
varieties of flexible metal tube assemblies is reproduced in Exhibit 1. 
Essentially, the product was an inner core of convoluted stainless steel 
tubing which looked something like a cylindrical accordion. The convolu- 
tions in the inner core permitted the tubing to be expanded, compressed, 
or curved in any direction. In a completed assembly the inner core was 
covered with a metallic braid and supplied with the appropriate kind of 
end fitting to adapt the assembly to the ultimate use planned by the 
purchaser. The FMT product line manufactured by Microflex included 
assemblies with an inside diameter ranging from % 6 on an inch up to 
2 inches. All assemblies were produced to customers' specifications con- 
cerning the length of the assembly (up to twenty feet) and the type of 
end fittings to be attached. 

The beginning of the Korean conflict and the accompanying increase 
in aircraft construction caused a rapid growth in business for Microflex 
during the early 1950's. Sales increased more slowly after 1955, but the 
high point was actually reached in 1957 when the sales volume was 
slightly in excess of $1,400,000. Income statements for the years 1958 and 
1959 are presented in Exhibit 2. Mr. Sears thought that the recent decline 
in sales volume was the joint effect of three causes: 

1. A decline in the importance of manned aircraft in governmental 
defense policy had reduced the number of military aircraft being 
constructed. Although FMT's were also used in rockets and missiles, 
the number of applications was not as great, and the volume of 
missile production was quite small when compared to the thousands 
of military aircraft built during the early 1950's. 

2. In recent years, a new type of flexible tubing assembly had been 



Microflex, Inc. 365 

developed by several of Microflex's competitors. This new product 
involved a plastic inner core covered by a metallic braid and, al- 
though not directly competitive in certain applications, had served 
to reduce this size of the market for Microflex's all-metal assembly. 
3. Flexible tubing assemblies of all descriptions seemed to be losing 
fashion among aeronautical engineers who regarded the use of such 
assemblies as inherently poor design. Wherever possible, the design 
engineers appeared to prefer a rigid tube or pipe to carry the gases 
or fluids. The utilization of a flexible tube assembly usually indicated 
a vibration problem which the engineer had been unable to solve. 

Anticipating the decline in the market for flexible metal tube assem- 
blies, Mr. Duncan formed a new company, Microflex Engineering Com- 
pany (MEC), in 1957. The primary purpose of MEC was to perform 
research and development work for Microflex in an attempt to find new 
products for the parent company. All the stock of MEC was owned by 
Microflex, and the majority of MEC income was provided by Microflex 
in the form of engineering fees. Recent income statements for MEC are 
presented in Exhibit 3. Eighty-two thousand dollars of MEC's 1958 sales 
and $102,000 of the 1959 sales were to the parent company. The remain- 
ing sales were from experimental and testing services performed for other 
business concerns in the Beverly Hills area. 

Early in 1959, Mr. Duncan, then in his early 60's, decided to retire 
from active management of the business and live abroad. He was able 
to persuade Mr. Donald J. Sears, then a vice president of a large Los 
Angeles bank, to accept the position as president. Mr. Sears assumed his 
duties in October 1959. Mr. Duncan retained 100 per cent stock owner- 
ship of the corporation, but Mr. Sears was granted certain stock options 
which were designed to permit him to acquire a significant percentage 
of the company's equity if he so desired. Mr. Duncan assumed the title 
of Director of Foreign Operations, and from his London office, he planned 
to promote the sale of Microflex's products in Europe and to continue his 
search for new products for the company. A final executive change in 
the fall of 1959 was the election of Mr. Lesley Curry to the newly created 
position of controller. 



PRICING POLICIES 

As a starting point for his investigation, Mr. Glickman decided to 
examine in greater detail the previous pricing policies of the company. 
First, he made a tour of the company's production facilities. All the 
company's administrative and manufacturing departments were housed in 
one steel building, consisting of four bays of about 3,000 square feet 
each. Although the company was not formally organized into depart- 



366 Microflex, Inc. 

merits, employees doing the same type of work were grouped together. 
At Mr. Glickman , s request, the production manager prepared the follow- 
ing analysis of floor space utilization. 

Analysis of Floor Space 

Square Feet 
Office bay (3,000 sq. ft.): 

Production control 400 

Purchasing 250 

Drafting 400 

Sales 500 

Accounting 300 

Executive 800 

Lavatories and miscellaneous 350 

Factory bays (9,000 sq. ft.): 

Machining 2,800 

Welding 800 

Assembly and final inspection 1,600 

Parts inspection 600 

Storeroom 1,500 

Shipping 300 

Carpenter shop 500 

Lavatories and miscellaneous 900 

Total 12,000 

In addition to this space, which the company owned, approximately 
5,000 square feet of space was rented at another location and was used 
exclusively by Microflex Engineering Corporation. Roughly 500 feet of 
the rented space was used as an office. 

An FMT assembly was not inherently complex in a technical sense, 
but because of the end use of the product, the assembly had to be 
produced to meet rigid "aircraft" specifications. As a result, a significant 
number of the factory employees were engaged in inspection and quality 
control activities rather than in direct manufacturing. All inner core 
( hose ) and outer covering ( braid ) were purchased from outside vendors. 
Because of satisfactory quality control by these vendors, the company 
did not inspect hose and braid (except for a quick visual inspection) 
until the final assembly was pressure tested for leaks or other defects 
just prior to shipping. End fittings were either purchased outside or 
manufactured in the company's machining department. Parts purchased 
outside were subjected to a rigid inspection of all critical dimensions 
before each lot was accepted. Parts manufactured by Microflex from 
aluminum or stainless steel bar stock were carefully inspected as they 
came off the machines. Only parts which passed inspection were allowed 
to enter the storeroom, where they were housed until issued for use on 
a specific production order. In the assembly department, the hose and 
braid were cut to appropriate lengths according to customers' specifica- 
tions, and the end fittings were attached either mechanically or by 
welding or brazing. 



Microflex, Inc. 367 

At Mr. Glickman's request, the accounting department prepared an 
analysis by function of the forty-six factory employees on the payroll in 
January 1960. Mr. Curry pointed out that the level of factory employ- 
ment had declined during 1959 so that the payroll for January 1960 was 
less than the average monthly factory payroll incurred during 1959. 

Analysis of Factory Labor, January 1960 

No. of Persons Payroll 

Machining department 11 $ 3,564 

Welding and brazing department .... 6 1,764 

Assembly department 11 3,126 

Experimental work at MEC 3 864 

Parts inspection 3 744 

Assembly inspection 4 976 

Storeroom 2 512 

Shipping 1 312 

General maintenance 4 1,048 

Truck driver JL^ 232 

Totals 46 $13,142 

Mr Glickman asked the sales manager, Mr. C. F. Wheaton, to describe 
the company's pricing procedures and any other background informa- 
tion pertinent to the current problem. Mr. Wheaton explained that Micro- 
flex employed no field salesmen, and that all orders were received through 
a firm of manufacturer's representatives called Technical Products Dis- 
tributors, Inc. (TPD). This firm specialized in distributing the products 
of small manufacturers supplying components to the aircraft and missile 
industry. TPD did not handle any product which was directly competitive 
with Microflex's line of FMT assemblies. According to TPD's manage- 
ment, its salesmen were well known in the engineering and purchasing 
departments of the aircraft companies. Mr. Wheaton felt that for a com- 
pany the size of Microflex, the use of a manufacturer's representative 
was not only more economical than using salesmen, but also permitted 
the company to get a broader and more intensive coverage of its market. 
Microflex paid TPD a 7 per cent commission on all orders (including 
repeat orders) received from customers serviced by TPD. Mr. Wheaton 
personally dealt with one nearby customer, and orders received from 
this customer were the only source of business to Microflex which were 
not subject to the 7 per cent commission. 

The primary function of the TPD salesmen was to convince the pur- 
chaser that Microflex might be the best supplier for the part desired and 
to secure the purchaser's permission for Microflex to submit a quote 
on the part. Almost all Microflex's orders resulted from such bids. If the 
customer agreed to solicit a bid from Microflex, detailed specifications 
for the required assembly were forwarded to Microflex, either directly 
by the customer or through the TPD salesman. Typically, purchasing 
agents in the aircraft industry would request quotes from two or more 



368 Microflex, Inc. 

suppliers. For small components such as those manufactured by Micro- 
flex, however, the purchasing agent would rarely bother to solicit more 
than three price quotations. 

All price quotations were prepared by Mr. Wheaton and his staff, 
using cost information provided by the production manager. Mr. Wheaton 
said that, depending on the level of business activity, his department 
prepared from 200 to 400 price quotations each month, and usually re- 
ceived between 100 to 200 orders per month. It was a rare order that 
exceeded fifty assemblies, and the usual order quantity was from three 
to thirty units. 

Mr. Wheaton explained that during the early 1950's, when the company 
was growing very rapidly, the method of determining price quotations 
had been quite informal. As an example of the way that he determined 
a price, he found in his files the work sheet that he had prepared for a 
part quoted in the summer of 1959. 

Part No. 6794 Quoted July 10, 1959 

Material cost $ 8.16 

Multiplier 2.5 

Total cost 20.40 

7% commission 1.60 

Total selling price $22.00 

To arrive at the price of $22 per unit, Mr. Wheaton had first asked 
the production manager for an estimate of the material cost in the as- 
sembly. The estimated cost of $8.16 represented the actual cost of pur- 
chased materials such as hose, braid, and certain end fittings, plus the 
production manager's estimate of the cost to Microflex for producing in 
its own machine shop the remaining end fittings which were not pur- 
chased outside. Mr. Wheaton then multiplied this material cost by a 
"factor" of 2y 2 . This factor varied, he said, depending upon his feel for 
the market and the reasonableness of the final price he arrived at. A 7 
per cent commission for TPD was then added to total cost to arrive at 
the total selling price. On this quotation for part No. 6794, Microflex 
received the order. 

As another example, Mr. Wheaton produced his worksheet for a very 
large FMT assembly which had been quoted on in February 1959. 

Part No. 4791 Quoted Feb. 18, 1959 

End fittings cost $ 45.00 

Multiplier 2 

Total for end fitting $ 90.00 

Hose and braid cost $172.00 

Multiplier 1.5 

Total for hose and braid 258.00 

Total cost $348.00 

Commission 26.00 

Total selling price $374.00 



Microflex, Inc. 369 

The pricing procedure for this part was essentially the same as for 
part No. 6794, except that in this case two different multipliers were 
used, a factor of 2 for the end fitting cost and a factor of V/ 2 for the 
cost of hose and braid. Mr. Wheaton explained that to use a larger 
multiplier on this assembly, where the cost of materials was very great, 
would result m a price which was too high to be successful. Microflex 
was successful in this price quotation and received an order for six 
units at a price of $374 each. 

In the summer of 1959, the volume of new orders received by Micro- 
flex began to decline sharply. Mr. Wheaton knew that this decline, in 
part, was due to the fact that the volume of business in the aircraft 
industry was declining. According to the TPD salesmen with whom Mr. 
Wheaton was in frequent contact, however, Microflex was suffering more 
from the decline than were its competitors. Apparently this was due to 
the fact that, as the volume of available business shrank, some suppliers 
were lowering their price quotations in an effort to achieve a greater 
percentage of the available business. In the face of this increasing com- 
petition, Mr. Wheaton had begun to feel less and less satisfied with his 
pricing procedures. He said that he had never been really "comfortable" 
with the method of pricing that he had been using, because it relied to 
a great extent on his personal judgment and his feel for the market. 
He pointed out that since he had very little direct contact with his cus- 
tomers, he did not think that his feel for the market was sensitive enough 
to measure the need for a small reduction in prices. Furthermore, he was 
uncertain as to the extent to which Microflex could reduce its prices and 
still operate profitably. Mr. Wheaton did not know how much prices 
needed to be cut in order to meet his competition, because the purchas- 
ing agents usually would not divulge to the unsuccessful bidder the price 
that had been quoted by the successful supplier. 

Another fault with the old method of determining prices was that, 
when Mr. Wheaton was out of the office, price quotations would be 
prepared by his assistant or other members of his staff, and these people 
might use a multiplier different from the one Mr. Wheaton might have 
used. 

Finally, Mr. Wheaton pointed out, the aircraft companies had recently 
been taking a greater interest in their suppliers' costs, and Microflex 
had received several requests from its customers to provide detailed cost 
information. As an example of these requests, Mr. Wheaton showed Mr. 
Glickman forms received from two major aircraft manufacturers ( Exhibits 
4 and 5). Mr. Wheaton knew that, under federal procurement regula- 
tions, these companies had a right to demand submission of these data, 
because parts manufactured by Microflex were being used on govern- 
ment contracts. Mr. Wheaton hesitated to refuse to supply the requested 
information because almost all Microflex's business came from about 



370 Microflex, Inc. 

twenty aircraft manufacturers, and he did not feel that he should jeopard- 
ize relationships with any of these important customers. 

Occasionally, Microflex received an order directly from a government 
agency, and was required to support its price with a detailed cost break- 
down. On two occasions during the past ten years, government auditors 
had appeared at the plant and asked to examine the company's books 
in order to verify the costs reported by the company. On these "re- 
negotiable" contracts, the auditors had refused to allow the company to 
charge certain expenses, such as experimental costs on new products, 
sales commissions, and certain other overhead items which were not 
"directly related to military business/' 

Mr. Wheaton did not think that orders received from aircraft com- 
panies were renegotiable in the sense that the price could be changed 
based on an examination of costs, but he was concerned about the reasons 
why these manufacturers, too, wanted the cost information. He had dis- 
cussed the matter with several TPD salesmen, and their impression was 
that the purchasing departments of the aircraft manufacturers examined 
the cost breakdowns to make sure that the suppliers' costs were approxi- 
mately in line with what was considered reasonable in the industry. For 
example, factory overhead rates usually exceeded 200 per cent of direct 
labor costs, but an overhead rate in excess of 300 per cent was con- 
sidered unacceptable unless supported by a detailed explanation of the 
allowable costs included in the overhead. Similarly, the administrative 
overhead rate usually ran from 20 to 30 per cent of factory cost, and the 
aircraft manufacturers were unwilling to pay a price which allowed the 
supplier a higher percentage for the general overhead. Sales commissions, 
identified as such, were not chargeable on government contracts, and the 
government was reluctant to allow a profit margin in excess of 10 per 
cent of the total price. 

Mr. Wheaton knew that Microflex was not bound by these industry 
practices in quoting prices to aircraft companies and, in fact, cost break- 
downs were usually not requested with the original price quotation. The 
problem was that, after Microflex was notified that it had received an 
order, the customer might then request the company to supply a cost 
breakdown to support the quoted price. In response to these requests, 
Mr. Wheaton prepared a set of figures that arrived at the required total 
amount, based on estimates of labor and material costs which allowed 
an overhead percentage that did not appear too high and a total cost 
breakdown that conformed to industry standards. He had never received 
any requests for further information about his cost breakdowns. He was 
not sure how he would respond if an auditor from one of his customers 
showed up to verify the cost information he had supplied. 

Because all these problems were related more or less directly to the 
company's pricing procedures, Mr. Wheaton's first recommendation to 
the new president, Mr. Sears, was that a new method of pricing be 



Microflex, Inc. 371 

devised. Mr. Sears, in turn, asked Mr. Curry to study the problem, and 
during the Fall of 1959 the three men worked together exploring alterna- 
tive pricing mechanisms. In November 1959, a large aircraft manufacturer 
asked Microflex to submit separate price quotations for nineteen different 
types of FMT assemblies. Microflex's management group decided to use 
this series of price quotations as a test of several different pricing for- 
mulas. The result of the experience was that Microflex received orders 
for only three of the nineteen components. TPD salesmen were normally 
unable to receive competitive price data, but because of the experimental 
nature of these price quotations, the salesman was able to obtain the 
lowest bid on each component. In sixteen instances, the successful bid 
was from 5 per cent to 50 per cent lower than Microflex's price, with the 
average successful bid from 10 to 20 per cent lower than Microflex. Mr. 
Wheaton showed Mr. Glickman the worksheets for several quotations 
used in this experiment. 

Part No. 7243 Quoted Nov. 17, 1959 

Material cost $74.69 

Multiplier 1.5 

Total for material ~ ~ $112.04 

Machining and assembly labor: 

6 hours at $3.00 $18.00 

Multiplier 3 

Total labor 54.00 

Total cost $166.04 

Commission 7.5% of cost 12.45 

Total selling price $178.49 

The quotation for part No. 7243 had been prepared by using the 
multiplier method but extending it to include a multiplication of labor 
costs as well as material costs. In this quotation, the estimate for material 
cost was the outside purchase price for all material used by Microflex, 
that is, the cost of parts machined by Microflex was estimated by in- 
cluding the cost of bar stock under material cost and specifically estimat- 
ing the amount of labor required for machining as a separate cost item. 
On this quotation, Microflex's price was high by $20, and the order was 
awarded to another bidder. 

Part No. 5797 Quoted Nov. 17, 1959 

Material cost $33.62 

Multiplier 1.5 

Total for material 50.43 

Machining and assembly labor: 

1% hours at $3.00 $4.50 

Multiplier 3 

Total cost for labor * 13.50 

Total cost 63.93 

Commission 4.80 

Total selling price 68.73 






372 Microflex, Inc. 

The quotation for part No. 5797 was prepared in exactly the same 
manner as that used for part No. 7243, and this bid was one of the three 
successful ones in the experiment. Mr. Wheaton pointed out that the 
only significant difference between the two parts was that No. 5797 had 
a lower direct labor cost in relation to direct material cost than No. 7243 
had. 

Part No. 6792 Quoted Nov. 17, 1959 

Material cost $ 68.58 

Machining and assembly labor: 

3.5 hours at $2.00 7.00 

Factory overhead 3.5 hours at $5.08 .... 17.78 

G and A overhead 3.5 hours at $5.69 19.91 

Total cost $113.27 

Profit 12Y 2 % of cost 14.16 

Total selling price $127.43 

The method used to quote on part No. 6792 was quite different from 
any procedure the company had ever used before, and represented the 
results of Mr. Curry's analysis of available cost information. Under this 
new procedure, material cost was the estimated purchase cost to Micro- 
flex and was not multiplied by any factor. Machining and assembly labor 
were costed at $2 per hour, factory overhead was then added at the 
rate of $5.08 for each labor hour, and general and administrative over- 
head was added at a rate of $5.69 for each labor hour. A profit equal to 
12y 2 per cent of the total cost was then added to arrive at the total sell- 
ing price. Microflex was the successful bidder on part No. 6792, but this 
same method of price determination was used on ten other parts in the 
experiment and, in each case, a competitor quoted a lower price than 
Microflex. In spite of this low success ratio using the new method, Mr. 
Wheaton thought it was an improvement over the old method because 
it added overhead based on direct labor costs, a procedure which was 
more in line with the normal costing formulas in the industry. He was 
still concerned, however, because Microflex's overhead rates, particularly 
the administrative overhead rate, was much higher than the industry 
norm. 

Since the November experiment, Mr. Wheaton told Mr. Glickman that 
he had continued to use a variety of pricing formulas, none of which 
had appeared to be more successful than any other. His enthusiasm for 
the new pricing formula had waned because of the results it had pro- 
duced on several occasions. 

Using the new formula on part No. 3472, Mr. Wheaton had arrived 
at a total price of $17.19. Microflex had produced this same part for the 
same customer early in 1958 and, at that time, had received a price of 
$18.10 per unit. As was usually the case when a customer reordered after 
a lapse of several months, the customer had requested a new price quota- 



Microflex, Inc. 373 

Part No. 3472 Quoted Dec. 4, 1959 

Material cost $ 6.21 

Assembly labor .71 hours 

at $2.00 1.42 

Factory overhead .71 hours 

at $5.08 3.61 

G and A overhead .71 hours 

at $5.69 4.04 

$15.28 

Profit 12y 2 % of cost 1.91 

Total selling price $17.19 

tion before placing a new order, and Mr. Wheaton had had to decide 
whether to quote on the business at a different price than the price used 
in 1958. He finally decided not to lower the price to that indicated by 
the pricing formula. The customer had placed an order for fifteen units 
when Mr. Wheaton informed him that the previous price of $18.10 was 
still effective. 

Part No. 5726 Quoted Jan. 11, 1960 

Material cost $ 9.84 

Assembly labor (.72 hours at $2.00) 1.44 

Factory overhead (.72 hours at $5.08) 3.66 

G and A overhead ( .72 hours at $5.69) 4.10 

Total cost $19.04 

Profit 12Y 2 % of cost 2.38 

Total selling price $21.42 

The request for a price quotation on part No. 5726 was also a reorder. 
The original price on this component had been $27, significantly higher 
than the price of $21.42 indicated by the new pricing formula. In this 
instance, Mr. Wheaton decided to lower the price for the reorder to 
$23.10 per unit, and the customer had accepted the new price. 

Near the end of their conversation, Mr. Wheaton showed Mr. Glick- 
man a request for a price quotation received that morning. The customer 
wished to reorder part No. 2764. The original order on this part had 
been placed in early May 1959 at a price of $27.38. 

Part No. 2764 First Sold on April 27, 1959 

End fittings cost $8.50 

Multiplier 2 

Total for end fittings ~~~~~ $17.00 

Hose and braid cost $5.09 

Multiplier 1.5 

Total for hose and braid 7.64 

Total cost $24.64 

Commission 7.5% 1.85 

Total selling price $26.49 



374 Microflex, Inc. 

In deciding whether or not to change the original price, Mr. Wheaton 
had figured what the price of this part should be, using the new pricing 
formula. 

New Quote Requested 
Part No. 2764 in February 1960 

Material cost: hose and braid $ 5.09 

nuts (purchased) 1.12 

bar stock .94 

Labor: Machining 2.30 hours 

Assembly .75 hours 

3^05 hours at $2.00 6.10 

Factory overhead 3.05 hours at $5.08 15.49 

G and A overhead 3.05 hours at $5.69 17.35 

Total cost $46.09 

Profit 12^% of cost 5.76 

Total selling price $51.85 

Since the price using the new method was nearly twice that computed 
by the old method, Mr. Wheaton examined the two calculations care- 
fully. He pointed out that the cost of materials to Microflex had not 
changed significantly during the period. The $8.50 cost for end fittings 
used in the original price quotation had represented the production 
manager's estimate of the cost of nuts, which were purchased outside, 
plus the cost of other end fittings which were manufactured by Micro- 
flex, using $.94 worth of bar stock and 2.3 hours of machining labor. 
When these costs were set out separately and the new pricing formula 
applied to them, the result was to increase the indicated price on the 
part to $51.85. Mr. Wheaton thought that the new pricing formula was 
more accurate than the old one, and it was obvious to him that the 
company had lost money on the part when it was produced at a price 
of $27.38. Nevertheless, he was sure that, if he quoted the price of $51.85 
to the customer, his bid would be rejected. Mr. Wheaton asked Mr. 
Glickman what price should be charged for this article, and Mr. Glick- 
man said that he would like to look at the cost records more carefully 
before attempting to answer the question. 



ADDITIONAL COST INFORMATION 

At Mr. Glickman's request, Mr. Curry described the accounting system 
used by Microflex. Mr. Curry said that his system was quite simple to 
operate because the company used only one income account for all sales, 
and maintained twenty-five expense accounts, one for each of the cate- 
gories shown in Exhibit 2. Mr. Curry then described the type of costs 
charged to certain accounts for which the title was not completely de- 
scriptive. The Methods and Product Engineering expense account rep- 



Microflex, Inc. 375 

resented payments by Microflex to its subsidiary, Microflex Engineering 
Corporation. The Outside Labor expense account received a variety of 
charges for miscellaneous services performed by outside contractors. At 
Mr. Glickman's request, a clerk in the accounting department reviewed 
the invoices charged to this account during 1959 and prepared the follow- 
ing tabulation. 

Outside Labor-1959 

Special services requested by customers: 

Packing and crating $ 3,462.33 

Rust proofing 2,278.95 

X-ray and other special testing 3,998.50 

Plating 606.51 

Parking lot repairs 990.49 

Pumping septic tank 982.00 

Unclassified 1,195.49 

Total $13,514.27 

The Factory Expense account received an even greater variety of 
charges. Mr. Curry explained that it would be almost impossible to 
analyze all the transactions in this account during 1959, because the goods 
and services received had been purchased from more than one hundred 
vendors. Mr. Glickman asked that an effort be made to pull out the 
most significant items included in the expense account, and the follow- 
ing analysis was prepared after several hours of work by a clerk in the 
accounting department. 

Factory Expense— 1959 

Manufacturing supplies and small tools $13,488.17 

Welding and brazing materials 4,487.01 

Inspection gauges and supplies 2,253.50 

Packing and shipping supplies 2,993.21 

Drafting supplies and equipment 1,414.35 

Building maintenance supplies and services 1,333.82 

Unclassified invoices 8,414.32 

Total $35,384.38 

The Freight account was primarily the expense incurred by Microflex 
on incoming shipments of supplies and materials purchased by Microflex. 
On most shipments of finished goods, freight was paid by the customer, 
but in some cases where freight cost was absorbed by Microflex, the 
expense was charged into the Freight account. 

Mr. Glickman also asked Mr. Curry for an analysis of the Office and 
Sales Salaries during 1959. Mr. Curry said this information would be 
relatively easy to obtain, but that it would not be too useful because 
the company had hired several new office employees, including himself 
and Mr. Sears, during the latter part of 1959. Instead, Mr. Curry prepared 
the breakdown of the charges to this account in January 1960, as shown 
below. 



376 



Microflex, Inc. 

Analysis of Office and Sales Salaries, January 1960 

No. of Persons Payroll 

Shop foreman 1 $ 480 

Production manager and staff 5 1,750 

Purchasing agent and clerk 2 650 

Drafting department 4 1,175 

Treasurer and clerk 2 940 

Office manager, receptionist, and 

secretaries 4 1,380 

Sales manager and staff 6 1,950 

24~ $8^25 



Mr. Curry said that he would be happy to provide Mr. Glickman with 
any additional information that he desired, if this information could be 
obtained from the available accounting records. 

Required 



1. Do you think the list of twenty -five expense accounts (Exhibit 2) provides 
adequate detail for management purposes? What new accounts, if any, 
would you establish? 

2. Using the account structure you recommended in Question 1, classify the 
accounts according to whether you consider the expense to represent (a) 
direct labor, (b) direct material, or (c) overhead. What subdivisions within 
the overhead group (factory overhead, selling overhead, and so forth) would 
you recommend? 

3. Using the expense classification you prepared in Question 2, devise a pricing 
formula for Microflex which you believe Mr. Wheaton and his staff should 
use for pricing new business and reorders. What price should be quoted 
for part No. 2764 in February 1960? 



EXHIBIT 1 



Flexible Metal Tube Assemblies 




rrr 



r* 









377 



EXHIBIT 2 



Statement of Income for 1958 and 1959 



1959 1958 

Net Sales $1,259,810 $1,321,056 

Cost of Goods Sold : 

Beginning inventory $ 184,244 $ 147,312 

Materials and supplies purchased 442,091 460,674 

Factory labor 255,833 252,718 

Methods and product engineering 102,000 82,000 

Outside labor 13,514 24,842 

Factory expense 35,384 34,610 

Heat, light, & power 5,950 6,789 

Insurance 4,285 5,921 

Depreciation 29,256 27,763 

Freight 8,172 11,716 

Repairs 2,485 5,136 

Rent 1,682 2,810 

Truck expense 784 1,384 

Subtotal $1,085,680 $1,063,675 

Less ending inventory 193,629 184,244 

Cost of goods sold $ 892,051 $ 879,431 

Gross profit $ 367,759 $ 441,625 

Administrative, Selling and Other Expenses : 

Executive salaries $ 50,247 $ 45,000 

Office and sales salaries 74,985 66,854 

Sales commissions 81,704 73,120 

Telephone and telegraph 14,571 11,699 

Travel and entertainment 24,414 28,505 

London office 23,115 

Taxes: property 3,077 3,163 

payroll 16,887 15,109 

Office supplies 7,915 10,971 

Postage, dues, subscriptions, etc 2,910 2,128 

Legal and audit services 10,615 7,195 

Advertising 14,475 3,813 

Employees Blue Cross 2,485 46 

Total expenses $ 327,400 $ 267,603 

Operating profit $ 40,359 $ 174,022 

Other income and expense (net) 1,927 (3,033 ) 

Profit before taxes $ 38,432 $ 177,055 

State and federal income taxes 16,400 91,203 

Net income $ 22,032 $ 85,852 



378 



EXHIBIT 3 



Microflex Engineering Company 
Statement of Income for 1958 and 1959 



1959 1958 

Sales $117,179 $96,051 

Cost of Sales : 

Materials purchased $ 10,947 $ 7,300 

Factory labor 51,569 36,199 

Outside labor 918 21 

Heat, light & power 2,130 295 

Factory supplies & expense 5,601 3,653 

Insurance 2,416 293 

Depreciation and amortization 10,078 6,403 

Freight 866 1,792 

Repairs 289 142 

Rent 6,699 1,320 

Decrease in inventory 3,584 2,506 

Total cost of sales $ 95,097 $59,924 

Gross profit $ 22,082 $36,127 

Administrative and Selling Expenses : 

Executive salary $ 4,100 $ 4,502 

Telephone and telegraph 1,944 1,664 

Office supplies, postage, dues, etc 777 989 

Advertising 1,013 819 

Travel and entertainment 237 513 

Commissions 131 289 

Legal and audit 1,968 1,578 

Taxes: property and misc 661 69 

payroll 2,967 1,317 

Automobile expense 349 168 

Total expenses $ 14,147 $11,908 

Operating profit $ 7,935 $24,219 

Other income and expenses (net) (28) 18 

Net profit before taxes $ 7,963 $24,201 

State and federal income taxes 2,696 8,192 

Net income $ 5,267 $16,009 



379 



EXHIBIT 4 



REQUEST FOR QUOTATION 

FORM 28-34B (REV. 11-84) 



EA-C 506 



0DI/GL, 



& 



YOUR QUOTATION IS REQUESTED ON ITEMS LISTED. 
PLEASE RETURN ORIGINAL AND ONE COPY NOT LATER 



DESCRIPTION AND SPECIFICATION 



•IT WILL BE ASSUMED THAT THE QUOTED PRICE INCLUDES ANY APPLICABLE 
FEDERAL EXCISE TAX UNLESS YOU HAVE LISTED IT SEPARATELY. 







MATERIAL DUE 


A.T DESTINATION AS FOLLOWS 






MONTH 


















QUANTITY 


















YOUR DEL'Y 
COMMITMENT 





DOUGLAS AIRCRAFT COMPANY, INC. 


BIIYFR _ 1 


PLEASE SUPPLY INDICATED REQUIREMENT 

C NO COST ANALYSIS REQUIRED. 

LJ ESTIMATED COST ANALYSIS REQUIRED. 


1. HAVE YOU IN THE LAST SIX MONTHS MANUFACTURED THIS OR A SUBSTANTIALLY 
SIMILAR ARTICLE? Q Y£S \J NQ 

2. IF ANSWER TO NO. t IS YES. WHAT IS THE LOWEST PRICE PAID BY CUSTOMER 


D ACTUAL COST ANALYSIS REQUIRED. 


3. ARE YOU PRESENTLY MANUFACTURING THIS OR A SUBSTANTIALLY SIMILAR 
ARTICLE? Q YES □ NQ 




4. IF ANSWER TO NO. 3 IS YES. WHAT IS THE LOWEST PRICE YOU ARE CURRENTLY 




5. ARE YOU PAYING ROYALTIES ON THIS ARTICLE? ~ J ~ J 




7. DOES THE SELLING PRICE TO US ON YOUR BID CONTAIN ANY BROKERAGE FEES 




OR COMMISSIONS TO OTHER PERSONS OR ORGANIZATIONS. INCLUDING SUB- 
SIDIARY OR AFFILIATED COMPANIES AND/OR YOUR OWN OFFICERS. PARTNERS. 
EMPLOYEES OR REPRESENTATIVES? Q Y£S [~J NQ 

IF ANSWER IS YES, GIVE NAME. AMOUNT, OR PERCENTAGE 






















THE ABOVE QUOTATION AND INFORMATION SUPPLIED IS ACCURATE TO THE BEST 




OF OUR KNOWLEDGE AND BELIEF. 














QFI 1 IMf5 pmr.F 





VENDOR'S AOENT 



TITLE OR CAPACITY 



380 



EXHIBIT 5 



COMPANY 



VENDOR COST BREAKDOWN (PRODUCTION) 
VENDOR PART NUMBER 
BOEING PART NUMBER 



EA-C 
506 



Date 



Units • We have previously manufactured 



Cost Breakdown for _ 

(Qty.) (Qty.) 

A separate Cost Breakdown should be made for each quantity quoted 



Units 



Direct Labor : 
Fabrication 
Processing 
Sub-Assembly 
Final Assembly 
Testing 



Overhead 
Hours Rate/Hour Total % Dollars 



If classified as Direct Labor: 

Planning 

Inspection 

Tool Maintenance 

Packaging & Shipping 

Other (Explain) 



Total Direct Labor plus Overhead on Direct Labor, 



Material : 



Raw Material 
Purchased Parts 
Subcontracted 

Material 

Labor 



Dollars $ Scrap 



Total 



Overhead 
% Dollars 



Total Direct Material plus Overhead on Direct Material. 



Engineering: (Sustaining) 

Other: % (Explain) 

Total Manufacturing Cost. . 



General & Administrative: 

Other: % (Explain) 

Profit: 

TOTAL 



$ PER UNIT 



Non-Recurring Cost 

Hours @ $ Per Hour 

Hours @$ Per Hour 

Tooling Material Cost 

Qualification Hours @ $ Per Hour 

Other Non-Recurring Cost (explain) 



Engineering 
Tooling 



Total Non-Recurring Cost 

Non-Recurring Cost Amortized 

(Qty.) 
TOTAL UNIT SELLING PRICE TO BOEING 



Unit: 



By (Signature) - Title 



381 



CASE 48 



Bill French, 
Accountant 



B 



ill French picked up the phone and called his boss, 
Wes Davidson, controller of Duo-Products Cor- 
poration. "Say, Wes, I'm all set for the meeting this afternoon. I've put 
together a set of break-even statements that should really make the boys 
sit up and take notice— and I think they'll be able to understand them, 
too." After a brief conversation about other matters, the call was con- 
cluded, and French turned to his charts for one last check-out before 
the meeting. 

French had been hired six months earlier as a staff accountant. He was 
directly responsible to Davidson and, up to the time of this case, had 
been doing routine types of analysis work. French was an alumnus of a 
liberal arts undergraduate school and graduate business school, and was 
considered by his associates to be quite capable and unusually conscien- 
tious. It was this latter characteristic that had apparently caused him to 
"rub some of the working guys the wrong way," as one of his co-workers 
put it. French was well aware of his capabilities and took advantage of 
every opportunity that arose to try to educate those around him. Wes 
Davidson's invitation for French to attend an informal manager's meet- 
ing had come as some surprise to others in the accounting group. How- 
ever, when French requested permission to make a presentation of some 
break-even data, Davidson acquiesced. The Duo-Products Corporation 
had not been making use of this type of analysis in its review or planning 
programs. 

382 



Bill French, Accountant 383 

Basically, what French had done was to determine the level of opera- 
tion at which the company must operate in order to break even. As he 
phrased it, "The company must be able at least to sell a sufficient volume 
of goods that it will cover all the variable costs of producing and selling 
the goods; further, it will not make a profit unless it covers the fixed, or 
non variable, costs as well. The level of operation at which total costs 
(that is, variable plus nonvariable) are just covered is the break-even 
volume. This should be the lower limit in all of our planning." 

The accounting records had provided the following information which 
French used in constructing his chart: 

Plant Capacity-2,000,000 units 

Past Year's Level of Operations— 1,500,000 units 

Average Unit Selling Price-$1.20 

Total Fixed Costs-$520,000 

Average Variable Unit Cost-$.75 

From this information, he observed that each unit contributed $.45 to 
fixed overhead after covering the variable costs. Given total fixed costs 
of $520,000, he calculated that 1,155,556 units must be sold in order to 
break even. He verified this conclusion by calculating the dollar sales 
volume that was required to break even. Since the variable costs per unit 
were 62.5 per cent of the selling price, French reasoned that 37.5 per 
cent of every sales dollar was left available to cover fixed costs. Thus, 
fixed costs of $520,000 require sales of $1,386,667 in order to break even. 

When he constructed a break-even chart to present the information 
graphically, his conclusions were further verified. The chart also made 
it clear that the firm was operating at a fair margin over the break-even 
requirements, and that the profits accruing ( at the rate of 37.5 per cent 
of every sales dollar over break-even) increased rapidly as volume in- 
creased (see Exhibit 1). 

Shortly after lunch, French and Davidson left for the meeting. Several 
representatives of the manufacturing departments were present, as well 
as the general sales manager, two assistant sales managers, the pur- 
chasing officer, and two men from the product engineering office. David- 
son introduced French to the few men that he had not already met, and 
then the meeting got under way. French's presentation was the last item 
on Davidson's agenda, and in due time the controller introduced French, 
explaining his interest in cost control and analysis. 

French had prepared enough copies of his chart and supporting calcula- 
tions so that they could be distributed to everyone at the meeting. He 
described carefully what he had done and explained how the chart 
pointed to a profitable year, dependent on meeting the volume of sales 
activity that had been maintained in the past. It soon became apparent 
that some of the participants had known in advance what French planned 
to discuss; they had come prepared to challenge him and soon had taken 



384 Bill French, Accountant 

control of the meeting. The following exchange ensued (see Exhibit 3 
for a checklist of participants with their titles ) : 

cooper [Production Control]: You know, Bill, I'm really concerned that you 
haven't allowed for our planned changes in volume next year. It seems to 
me that you should have allowed for the sales department's guess that we'll 
boost sales by 20 per cent, unit-wise. We'll be pushing 90 per cent of what 
we call capacity then. It sure seems that this would make quite a differ- 
ence in your figuring. 

French: That might be true, but as you can see, all you have to do is read the 
cost and profit relationship right off the chart for the new volume. Let's 
see— at a million-eight units we'd. . . . 

Williams [Manufacturing]: Wait a minute, nowl If you're going to talk in 
terms of 90 per cent of capacity, and it looks like that's what it will be, you 
damn well better note that we'll be shelling out some more for the plant. 
We've already got okays on investment money that will boost your fixed 
costs by $10,000 a month, easy. And that may not be all. We may call it 
90 per cent of plant capacity, but there are a lot of places where we're just 
full up and we can't pull things up any tighter. 

cooper: See, Bill? Fred Williams is right, but I'm not finished on this bit about 
volume changes. According to the information I've got here— and it came 
from your office— I'm not sure that your break-even chart can really be used 
even if there were to be no changes next year. Looks to me like you've got 
average figures that don't allow for the fact that we're dealing with three 
basic products. Your report here [see Exhibit 2] on costs, according to 
product lines, for last year makes it pretty clear that the "average" is way 
out of line. How would the break-even point look if we took this on an 
individual product basis? 

French: Well, I'm not sure. Seems to me that there is only one break-even 
point for the firm. Whether we take it product by product or in total, we've 
got to hit that point. I'll be glad to check for you if you want, but .... 

bradshaw [Asst. Sales Mgr.]: Guess I may as well get in on this one, Bill. If 
you're going to do anything with individual products, you ought to know 
that we're looking for a big swing in our product mix. Might even start 
before we get into the new season. The "A" line is really losing out, and I 
imagine that we'll be lucky to hold two-thirds of the volume there next 
year. Wouldn't you buy that, Arnie? [Agreement from the General Sales 
Manager] That's not too bad, though, because we expect that we should 
pick up the 200,000 that we lose, and about a quarter million units more, 
over in "C" production. We don't see anything that shows much of a 
change in "B." That's been solid for years and shouldn't change much 
now. 

winetki [Gen'l. Sales Mgr.]: Bradshaw's called it about as we figure it, but 
there's something else here too. We've talked about our pricing on "C" 
enough, and now I'm really going to push our side of it. Ray's estimate of 
maybe half a million— four hundred fifty thousand, I guess it was— up on 
"C" for next year is on the basis of doubling the price with no change in 
cost. We've been priced so low on this item that it's been a crime— we've 
got to raise, but good, for two reasons. First, for our reputation; the price is 
out of line class-wise and is completely inconsistent with our quality repu- 
tation. Second, if we don't raise the price, we'll be swamped and we can't 
handle it. You heard what Williams said about capacity. The way the 
whole "C" field is exploding, we'll have to answer to another half million 



Bill French, Accountant 385 

units in unsatisfied orders if we don't jack that price up. We can't afford 
to expand that much for this product. 

At this point, Hugh Fraser, administrative assistant to the president, 
walked toward the front of the room. The discussion broke for a minute, 
and he took advantage of the lull to interject a few comments. 

fraser: This has certainly been enlightening. Looks like you fellows are pretty 
well up on this whole operation. As long as you're going to try to get all 
the things together that you ought to pin down for next year, let's see what 
I can add to help you. 

Number one: Let's remember that everything that shows in the profit 
area here on Bill's chart is divided just about evenly between the govern- 
ment and us. Now, for last year we can read a profit of about $150,000. 
Well, that's right. But we were left with half of that, and then paid out 
dividends of $50,000 to the stockholders. Since we've got an anniversary 
year coming up, we'd like to put out a special dividend of about 50 per 
cent extra. We ought to hold $25,000 in for the business, too. This means 
that we'd like to hit $100,000 after the costs of being governed. 

Number two: From where I sit, it looks like we're going to have to talk 
with the union again, and this time it's liable to cost us. All the indications 
are— and this isn't public— that we may have to meet demands that will 
boost our production costs— what do you call them here, Bill— variable 
costs— by 10 per cent across the board. This may kill the bonus-dividend 
plans, but we've got to hold the line on past profits. This means that we 
can give that much to the union only if we can make it in added revenues. 
I guess you'd say that that raises your break-even point, Bill— and for that 
one I'd consider the company's profit to be a fixed cost. 

Number three: Maybe this is the time to think about switching our 
product emphasis. Arnie Winetki may know better than I which of the 
products is more profitable. You check me out on this Arnie— and it might 
be a good idea for you and Bill French to get together on this one, too. 
These figures that I have [Exhibit 2] make it look like the percentage 
contribution on line "A" is the lowest of the bunch. If we're losing volume 
there as rapidly as you sales folks say, and if we're as hard pressed for 
space as Fred Williams has indicated, maybe we'd be better off grabbing 
some of that big demand for "C" by shifting some of the facilities over 
there from "A." 

That's all I've got to say. Looks to me like you've all got plenty to talk 
about. 
Davidson: Thanks, Hugh. I sort of figured that we'd get wound up here as 
soon as Bill brought out his charts. This is an approach that we've barely 
touched, but, as you can see, you've all got ideas that have got to be made 
to fit here somewhere. I'll tell you what let's do. Bill, suppose you rework 
your chart and try to bring into it some of the points that were made here 
today. I'll see if I can summarize what everyone seems to be looking for. 

First of all, I have the idea buzzing around in the back of my mind that 
your presentation is based on a rather important series of assumptions. 
Most of the questions that were raised were really about those assumptions; 
it might help us all if you try to set the assumptions down in black and 
white so that we can see just how they influence the analysis. 

Then, I think that Cooper would like to see the unit sales increase taken 



386 Bill French, Accountant 

up, and he'd also like to see whether there's any difference if you base the 
calculations on an analysis of individual product lines. Also, as Bradshaw 
suggested, since the product mix is bound to change, why not see how 
things look if the shift materializes as Sales has forecast. 

Arnie Winetki would like to see the influence of a price increase in the 
"C" line, Fred Williams looks toward an increase in fixed manufacturing 
costs of $10,000 a month, and Hugh Fraser has suggested that we should 
consider taxes, dividends, expected union demands, and the question of 
product emphasis. 

I think that ties it all together. Let's hold off on our next meeting, fel- 
lows, until Bill has time to work this all into shape. 

With that, the participants broke off into small groups and the meet- 
ing disbanded. French and Wes Davidson headed back to their offices 
and French, in a tone of concern asked Davidson, "Why didn't you warn 
me about the hornet's nest I was walking into?" 

"Bill, you didn't ask!" 



Required 

1 . What are the assumptions implicit in Bill French's determination of his com- 
pany's break-even point? 

2. On the basis of French's revised information, what does next year look like: 

(a) What is the break-even point? 

(b) What level of operations must be achieved to pay the extra dividend, 
ignoring union demands? 

(c) What level of operations must be achieved to meet the union demands, 
ignoring bonus-dividends? 

(d) What level of operations must be achieved to meet both dividend and 
expected union requirements? 

3. Can the break-even analysis help the company decide whether to alter the 
existing product emphasis? What can the company afford to invest for addi- 
tional "C" capacity? 

4. Is this type of analysis of any value? For what can it be used? 






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387 



EXHIBIT 2 



Product Class Cost Analysis 
(Normal Year) 



Aggregate 

Sales at full capacity (units) . 2,000,000 
Actual sales volume (units). . 1,500,000 

Unit sales price $1.20 

Total sales revenue $1,800,000 

Variable cost per unit .... $0.75 

Total variable cost $1,125,000 

Fixed costs $ 520,000 

Net profit $ 155,000 

Ratios: 

Variable cost to sales . .63 

Variable income to sales .37 

Utilization of capacity . 75.0% 



600,000 


400,000 


500,000 


$1.67 


$1.50 


$0.40 


$1,000,000 


$600,000 


$200,000 


$1.25 


$0,625 


$0.25 


$ 750,000 


$250,000 


$125,000 


$ 170,000 


$275,000 


$ 75,000 


$ 80,000 


$ 75,000 


-0- 


.75 


.42 


.63 


.25 


.58 


.37 


30.0% 


20.0% 


25.0% 



EXHIBIT 3 



List of Participants in the Meeting 



Bill French— Staff Accountant Ray Br adshaw— Assistant Sales Manager 

Wes Davidson— Controller Arnie Winetki— General Sales Manager 

John Cooper— Production Control Hugh Fraser— Administrative Assistant 
Fred Williams -Manufacturing t0 President 



388 






CASE 49 



Redwood 
Memorial Park 



E 



arly in July 1960, Mr. Jedamis, president and gen- 
eral manager of Redwood Memorial Park, con- 
tacted Mr. Ferns, junior partner in the local office of a large national 
public accounting firm, and asked the firm to prepare financial statements 
for Redwood Memorial Park. Mr. Jedamis was interested in raising 
additional capital to finance the continued expansion of facilities at Red- 
wood Memorial Park, located outside Glendale, California. In connection 
with this financing, Mr. Jedamis had approached a number of banks and 
private investors, and in each contact he was requested to produce fi- 
nancial statements. Prior to 1960, such requests would have presented 
no problem, since Mr. Jedamis had always employed an accountant to 
maintain the required records and to prepare financial reports. (The 
balance sheet for the year ending June 30, 1959, is reproduced as Exhibit 
1. ) In 1959, however, the accountant had resigned, and Mr. Jedamis had 
turned this function over to Mrs. Hobson, a clerk in the office. He as- 
sumed that she could perform the job adequately, but when he had 
requested the annual financial reports for the year ending June 30, 1960, 
he was shocked to learn that no such reports were available and that the 
records had been maintained in such a way that he himself was unable to 
compile the required statements. 

Mr. Ferns agreed to prepare the requested financial statements and 
to appraise the operating results for the year just completed. He also 

389 



390 Redwood Memorial Park 

agreed to make recommendations which would improve the company's 
reporting and accounting procedures. 



HISTORY OF REDWOOD MEMORIAL PARK 

In 1947, Mr. Jedamis, an independent financier, and four business 
associates purchased all the outstanding Redwood land certificates for 
a price of $385,000. The land certificates had originally been issued in 
1892 ( under a franchise granted by the City of Glendale, California ) and 
carried with them the right to receive 50 per cent of the proceeds x of 
any land sold from the 360 acres of land which had been zoned for 
cemetery use. The cemetery itself was to retain the other 50 per cent 
of sales proceeds for current operating and land development expense. 

However, very little cemetery development work had taken place prior 
to 1947 because no one felt that the cemetery could be operated profit- 
ably on 50 per cent of the sales proceeds specified by the franchise for 
operating expense, and hence no one assumed responsibility for the 
cemetery's operation. But Mr. Jedamis saw an opportunity for profit not 
in the operation of the cemetery itself, but in the land certificate shares 
which permitted their holders to receive 50 per cent of the sales proceeds 
with no further obligations on their part. This, he felt, was a unique 
opportunity since very few cemetery franchises (the right to operate a 
cemetery granted by a local municipality) had been granted which per- 
mitted private investors to hold the land certificates. The majority of 
franchises had been granted to fraternal organizations, religious groups, 
and other nonprofit institutions. 

The cemetery was organized as a separate legal corporation but had 
issued no stock and, in effect, owned itself. It was not owned by the 
holders of the land certificates, nor was it owned by those who had 
purchased plots in the cemetery, since they had the right to use the land 
for eternity, but did not legally hold title to it. The 360 acres of land 
was owned by the holders of the land certificates until it was sold as 
burial plots. At that time, the title to the specific land plots passed to 
the Cemetery Corporation. 

Although there was no legal relationship between the certificate hold- 
ers and the cemetery, other than that described above, the nature of this 
relationship gave the certificate holders an incentive to promote the sale 
of plots in the cemetery. Because of this, Mr. Jedamis assumed the posi- 
tion of president and general manager of the Cemetery Corporation and 

1 "Proceeds" was defined in the franchise as follows: "The proceeds of lot sales 
should be computed on the basis of the gross amount charged for the sale of the 
use of lots or plots, excluding charges for endowment care thereon, less cash dis- 
counts allowed, and, less compensation of all salespersons. In general, the term 'com- 
pensation' is limited to salaries and commissions paid to salesmen and sales managers." 



Redwood Memorial Park 391 

hired a superintendent to run the cemetery. All expenses connected with 
the cemetery's development, promotion, and maintenance were incurred 
by the Cemetery Corporation and were to be recovered from its share of 
the sales proceeds. 

To further encourage and finance the cemetery's development the cer- 
tificate holders had, since the cemetery's reactivation in 1947, permitted 
the Cemetery Corporation to use their share of the sales proceeds (at 
no interest). Their share, to June 30, 1959, amounted to $1,099,111.96 
and represented the cost of raw land to the cemetery on gross sales of 
$4,622,592.44. Mr. Jedamis planned the promotion of the cemetery as a 
memorial park rather than merely maintaining it as a graveyard which 
would have been consistent with industry practice at the time. Mr. 
Jedamis described the difference between a graveyard and a memorial 
park in a speech he gave to the Glendale Chamber of Commerce by 
saying, 

For hundreds of years the word "cemetery" has been associated with 
the cold, dismal utility of a hole in the ground to be used for the disposi- 
tion of human remains after death. The word commonly conveys a feeling 
of morbidness, gruesomeness, and unhappiness, and acts to repel people 
from anyone or anything associated with it. My associates and I have pro- 
moted Redwood Memorial Park on the basis of life and beauty rather than 
sadness and death. It is a garden of beauty rather than a graveyard. We 
have constructed lakes, fountains, memorial arches, and an outside me- 
morial chapel where services can be performed under the open skies. We 
have preserved the natural trees in the area and planted scores of different 
varieties of flowering shrubs and perennial plants, and all of this has been 
done in accordance with a landscaping plan that provided for division of 
the memorial park into sectors which were patterned after some Biblical 
garden, for example, the Garden of Gethsemane. And perhaps most im- 
portant, the gravestone or tomb marker has been eliminated except for 
a small bronze plate which has been placed at the point of burial but 
flush with the ground. The final result of this idea has been the trans- 
formation of the historic graveyard into an outdoor art gallery set in 
a beautiful garden [see Exhibit 2], 

The memorial park concept had practical significance as well as es- 
thetic value. Normal maintenance of the grounds was one-tenth as great 
as in the typical graveyard since the area could be cared for by ganged 
power equipment rather than requiring the extensive handwork of a 
typical graveyard. The park also eliminated the factor of economic 
status, as measured by the size of a marble monument, since all markers 
were flush with the ground and were the same size. One exception to 
this was the "estate," a block of from 10 to 15 spaces set aside for one 
family. It contained special landscaping, a memorial bench, and a bronze 
plaque with the family name on it. 

The major source of Redwood's income was from the sale of land as 
burial plots. The major cemetery expense was the cost of land com- 



392 Redwood Memorial Park 

posed of two parts: first, the cost of the raw land itself (50 per cent of 
the sales "proceeds" paid to Mr. Jedamis and his associates ) , and second, 
the cost of developing the raw land into a form suitable for burial plots. 

SALES INCOME 

The cemetery had three types of sales income during the year: (1) 
sale of land as burial plots, (2) sale of burial services (the interment), 
and (3) sale of bronze burial markers. 

The largest part of the cemetery's income in 1960 was from the sale of 
burial plots on a pre-need basis. The selling approach stressed the im- 
portance of providing the family with burial facilities before the need 
for such facilities actually arose, thus alleviating the sorrow of the family 
at the time of a death. A sale consisted of one or more burial spaces, but 
the typical purchase was a lot ( four spaces ) . 

The price of a space, which ranged from $125 to 250, or the price of 
an estate (10 to 15 spaces) which sold for $6,000 to $8,000, depended 
upon a number of factors. First was the nearness of the space to the 
feature piece in each section or garden such as the cross, rose arbor, 
the chapel, walkways, or pieces of shrubbery. These features increased 
the value of the plot. Second was the degree of completion or sales 
saturation level of each section. The sales manager stated that, "The 
nearer a section approaches saturation, the higher the price of the plots 
becomes, since most of the development costs have then already been 
recovered and thus there is not as much pressure from management 
to sell such lots. Also, the first spaces in a newly developed section are 
hardest to sell— therefore a lower price. The real criterion is the old axiom 
of supply and demand. You get what the market will bear for the spaces." 
The average purchase in 1960 was $600 or 3.0 spaces. 

A space could be purchased for cash or could be paid for over a period 
of time. No interest was charged on a purchase which was paid for over 
a period of time, but a 15 per cent price reduction was given to the 
purchaser if he paid for his plot within 30 days after purchase. This 15 
per cent discount amounted to $9,341.09 during the fiscal year just ended. 

Total plot sales for the year were $497,397.50, as shown in Exhibit 3. 
However, this figure did not reflect certain sales cancellations. A sale 
could be cancelled by the customer directly, or by his failure to make 
the stipulated monthly payment on his sales contract, but any money 
which he had paid toward the purchase of a plot was forfeited by him, 
and the land spaces were then returned to the inventory of unsold spaces. 
The sales which were cancelled during the fiscal year 1960 are listed in 
Exhibit 3. 

Redwood charged $70 for each interment (burial), and received $28,- 
000 from this source during 1960. This price covered opening the space, 



Redwood Memorial Park 393 

the graveside service, and the work necessary to restore the sod to its 
original condition. During the same period of time, the income from 
installation of bronze markers amounted to $18,282.50. Redwood Memo- 
rial Park did not sell the markers, but installed them for an average 
price of $40. 

SALES, SALARIES, AND COMMISSIONS 

When a sale was written up, the salesman making the sale received his 
commission on the sale in full before the company was permitted to re- 
ceive the balance of the sales proceeds. On cash sales this presented no 
problem, since the salesman was paid his commission at once and the 
company likewise received the balance of the sales proceeds immediately. 
However, a sale on account required additional bookkeeping, since the 
down payment on the sale plus the first several monthly payments be- 
longed to the salesman as sales commission. Once the sales commission 
had been paid in full, future installment payments belonged to the com- 
pany. The company allowed the salesman to collect his commission from 
the first money received from a sale (called "front money"), but did not 
pay him the full commission until the sales contract had "thrown off" 
the required cash. When a sales contract was cancelled before it was fully 
paid, no refund of commissions already paid the salesman was required, 
but likewise, any unpaid commission was cancelled at the time of sales 
cancellation. Sales cancellations and the related sales commissions are 
listed in Exhibit 3. 

The sales force received $75,834.72 of sales commissions in cash during 
the fiscal year just ended, but $30,034.72 of this amount represented the 
payment of commissions which had been owed to the sales force on June 
30, 1959 ( see Exhibit 1 ) . In addition to the balance of sales commissions 
still due the sale force (as of June 30, 1960) from sales made in fiscal 
years prior to 1960, Redwood owed $32,968 in sales commissions on sales 
made during the 1960 fiscal year. Of this amount, $12,033 represented 
commissions on contracts from which the required front money had been 
received from the purchaser, but had not yet been paid to the salesmen, 
and $20,935 was the amount of sales commissions on sales contracts which 
had been consummated but from which the cash throwoff (front money), 
needed to cover the sales commissions, had not been collected as of June 
30, 1960. As of the same date, cash advances of $20,800 were outstanding 
against these deferred commissions. The sales manager and his staff were 
paid salaries of $60,225 during the fiscal year just ended. 

ACCOUNTS RECEIVABLE 

Accounts Receivable from lot purchasers amounted to $639,810.28 as 



394 Redwood Memorial Park 

of June 30, 1960. An aging of these accounts was available and has been 
reproduced as Exhibit 4. No reserve for bad debts had been established. 
In addition to these amounts, $16,411.85 of customers' notes had been 
discounted at the Sun Valley Trust Company with a 20 per cent reserve 
withheld by the bank on the total amount of discounted notes. The value 
of any noncollectible notes would be deducted by the bank from this 
reserve. It was also noted that as of June 30, 1960, the U. S. Trust Com- 
pany held $35,000 of discounted notes on which the cemetery was con- 
tingently liable. No reserve had been withheld on these notes since the 
bank had full recourse against the cemetery. The total cost of discounting 
to the cemetery for the year was $575.82. 



COST OF LAND TO REDWOOD MEMORIAL PARK 

The cost of the cemetery land was the largest expense incurred by the 
cemetery during the fiscal year ending June 30, 1960, and was composed 
of two parts: first, the portion of the sales proceeds which had to be 
paid to the land certificate holders, and second, the cost of developing 
the land into a memorial park. 

Before the raw land was sold as burial plots, it was graded, subdivided 
into spaces, and landscaped. The grading required heavy construction 
equipment and skilled operators, the subdividing required a landscape 
artist and a surveying team, and landscaping required not only labor 
but tons of grass seed, scores of shrubs, and a large amount of cement 
for walkways and feature pieces. It had not been possible to accumulate 
these direct costs by individual lots, but the costs had been accumulated 
by sections of the cemetery. These costs had been accumulated in a 
suspense account, the cemetery development cost account (see Exhibit 
5), but this account did not include the indirect costs incurred by the 
ground's crew in land development work. 

Land development was not carried out on a prescheduled basis but 
was initiated by the cemetery's ground maintenance crew during the 
winter months in its spare time. When other duties permitted, the crew 
cleared the brush and trees off the land in preparation for the grading 
and leveling to be performed by an outside contractor. The roads, walk- 
ways, and all feature pieces were also constructed by noncemetery per- 
sonnel. The grass was planted by the maintenance crew in the spring, if 
time was available, but if time did not permit, this work was contracted 
out. The time spent by the maintenance crew in land development had 
not been charged to the land development account in previous years but 
had been treated as a current operating cost. ( See succeeding section on 
operating costs and Part 2 of Exhibit 7 for a summary of these costs. ) 

The direct cost of developing the land into a memorial park ( grading, 



Redwood Memorial Park 395 

roadway construction, seeding, and so on ) amounted to $583,882.57 from 
the cemetery's inception to June 30, 1959, as shown in column 6 of 
Exhibit 5 (prepared by Mr. Martin, Redwood's previous accountant). 
However, as of June 30, 1959, $311,875.58 of this amount had already 
been charged off against income as the cost of land development allocated 
to the 30,193 spaces sold from the cemetery's inception to June 30, 1959. 
A balance of $272,006.99 remained in this deferred expense account as 
of June 30, 1959 (see Exhibit 1). As shown in Exhibit 5, the land de- 
velopment cost was allocated to the spaces sold on a percentage of com- 
pletion method. The estimated percentage of completion (column 4, 
Exhibit 5) was determined by the park superintendent each year and 
could increase or decrease from year to year. The park Superintendent's 
estimate was based on his judgment of the physical level of completion 
of a section rather than on a precisely calculated percentage based on 
dollar completion of a section. This figure could be changed by several 
events: first, additional expenditures on a section bringing it closer to 
completion; second, an increase (or decrease) in the estimate of labor 
and material required to complete the section which would decrease ( or 
increase) the percentage of completion; third, variance caused by human 
error in estimating from year to year; and fourth, the landscape plan of 
a section might be redesigned which in turn would affect the number 
of spaces (or unsalable spaces) in a section. The park superintendent's 
estimates of percentage of completion and other section data were sum- 
marized for the year 1960 and are reproduced as Exhibit 6. 

The direct development costs of $31,387.50 for the 1960 fiscal year 
were: architect fees, $3,003.28, equipment rentals, $8,378.20, construction 
materials, $16,728.16, and direct general labor, $3,277.86. These costs 
were broken down by section as shown in Exhibit 6. The number of 
spaces sold during 1960 was 2,483, but Mrs. Hobson, the bookkeeper, 
was uncertain about the method of allocating to these spaces some por- 
tion of deferred development costs. She did not know whether to charge 
income from these spaces with fiscal year direct costs of $31,387.50, an 
average cost based on previous allocations, or some other cost computed 
on a percentage of completion basis from the information available ( Ex- 
hibits 5 and 6). 

COST OF OPERATING AND MAINTAINING 
REDWOOD MEMORIAL PARK 

Exhibit 7 is a reproduction of a summary of the expense accounts for 
the fiscal year ending June 30, 1960, as given to Mr. Ferns. Part 1 listed 
the expenses connected with the general operation of the cemetery and 
the business office. Part 3 listed the company's fixed assets and the de- 
preciation accumulated to June 30, 1959. 



396 Redwood Memorial Park 

Part 2 described those costs associated with the annual maintenance 
of the cemetery, indirect costs of land development, costs incurred in 
preparing for interments, and costs related to the installation of bronze 
markers. These costs had not been maintained separately for each of 
the above operations. 

The grounds crew of twelve men, the park superintendent, and a four- 
month summer work force of five men, performed the operations noted 
in the preceding paragraph. This work force was subdivided into five 
functional crews. First was the gardening crew composed of four regulars 
and three summer men. From April through September, this crew spent 
its full time trimming shrubs, edging walkways, weeding and mulching 
flower beds, and generally caring for the cemetery's flowers and shrubs. 
During the remaining months of the year, the crew spent its time remov- 
ing and replanting dead shrubs and other plants, cleaning and repairing 
equipment, and cutting brush on undeveloped land in preparation for 
grading. The crew spent approximately one-third of its time on each of 
these activities during the winter months. 

The second crew, the interment crew, consisted of four regular em- 
ployees whose job was to prepare for interments, install bronze markers, 
and to assist the garden crew when no interment or marker work was 
available. It normally took the crew three hours to prepare an interment 
and replace the sod, and generally required 50 minutes to install a 
bronze marker and its cement base. Because there was no seasonality 
to interments, the crew spent most of its time year-round on interments 
and marker installations, but did assist the garden crew in grounds 
maintenance from April to October and in land development the re- 
mainder of the year in any spare time. 

The third crew, the estate crew, was composed of one regular and one 
summer employee. This crew spent the summer months cutting grass 
with hand mowers in the estate sections, since the shrubbery which was 
used to form a border around each estate prohibited the use of ganged 
power mowers. Approximately 90 per cent of all shrubbery in the ceme- 
tery had been planted on estate plots to set them off from the general 
cemetery spaces. The regular employee of this crew spent the rest of the 
year pruning trees or assisting in the reseeding and replanting of various 
areas of the cemetery. 

Fourth was the grass-mowing crew which consisted of two regular and 
one summer employee who operated the ganged power mowers used in 
cutting the lawn. This was a full-time job from April to October, but 
during the rest of the year this crew cleaned, oiled, and repaired main- 
tenance equipment, and worked on undeveloped land clearing off brush 
and trees or planting new lawn. Their time was equally divided between 
these two activities. 

Finally, one regular employee spent full time manufacturing cement 



Redwood Memorial Park 397 

bases for the bronze markers and acting as custodian for the cemetery 
garage. His workshop was housed in the garage and thus he could sign 
out equipment and issue supplies without interfering with the manu- 
facture of cement bases. 

The park superintendent stated that the average salary of a regular 
employee was $4,500 a year and that the summer help was typically paid 
$300 per month. He further commented that the cost of maintaining a 
section was constant regardless of the number of interments which had 
been made in the section and that a regular crew of twelve men was 
required to care for the cemetery even if no land development work was 
carried out. Land development was a spare time activity and was only 
performed when the men were not occupied by maintenance work and 
during time which otherwise would have been wasted. The land develop- 
ment work of the ground's crew was confined to three sections during the 
1960 fiscal year. Roughly one-half of its spare time was spent in section 
10, and the remainder of its activity was equally split between sections 
7 and 11. 

In order to insure the lot purchaser that his plot would be cared for 
eternally, Redwood set aside a portion of the sales price of each plot to 
be deposited in a perpetual care fund, the income from which was to 
be used to defray the cost of future cemetery maintenance. When closing 
a sale, the sales force stressed the importance of the perpetual care clause 
in the contract. Each sales contract contained a clause which stated that 
the cemetery would maintain the burial space in a park-like surrounding 
for eternity. The sales manager expressed this sales philosophy in an 
article he had written when he said, "We are not selling graves— we are 
giving comfort and courage to the living not only through our counselors 
but by assuring them that their final resting place will be eternally 
cared for." 

When a sale was made, 10 per cent of the gross sales price of the plot 
was deducted from the proceeds and deposited in an irrevocable trust 
fund at the Sun Valley Trust Company. This trust fund deposit was not 
refundable and if for any reason the lot was returned to the cemetery at 
a future time, the original trust fund deposit could not be transferred or 
used to offset a deposit that Redwood had not yet made on another sales 
contract. Likewise, if a returned lot was sold a second time, a second 
deposit was required by the trust company. If an estate was sold, a 25 
per cent deduction was made, since an estate required considerably more 
upkeep and thus required a larger deposit in order to provide the income 
necessary for perpetual care. The management of Redwood hoped that 
the income from this trust fund would provide for the cost of perpetual 
maintenance care of the cemetery. This was an important selling point 
and space purchasers were extremely interested in knowing that future 
care of their plot was insured. 



398 Redwood Memorial Park 

The balance of this fund in the Sun Valley Trust Company as of June 
30, 1959, was $406,426.89, and $41,967.76 had been deposited to this 
trust fund during the 1960 fiscal year. However, in addition to the amount 
in the fund on June 30, 1959, Redwood owed the trust company $147,- 
167.61 on sales made, but on which the cash had not yet been remitted 
to the trust company (see Exhibit 1). The trust company permitted the 
cemetery to retain the 10 per cent ( or 25 per cent on estate sales ) endow- 
ment deduction until the final payment had been received from a sales 
contract, but the entire liability became payable as of the end of the 
quarter in which the final sales installment was received. During the 
second quarter of 1960, $28,933.07 of the endowment liability had been 
collected, but this amount had not been deposited with the Sun Valley 
Trust Company as of June 30, 1960. An income statement from this fund 
showed that Redwood had received income of $17,379.38 for the 1960 
fiscal year. 

Required 

1. Prepare an example showing the ultimate distribution of the selling price of 
a space. 

2. Determine the gross margin on lot sales made during the fiscal year ending 
June 30, 1960, with particular emphasis on the cost of spaces sold during 
the year. 

3. Prepare financial statements for Mr. Jedamis for the fiscal year ending June 
30, 1961. Don't "plug" the ending cash amount figure. Show the calculation 
by which it was computed. Would you recommend that Mr. Jedamis use 
these statements in support of his loan request to the bank? 

4. Is the perpetual care fund plan adequate to provide for the "eternal" mainte- 
nance of purchasers' plots? 



EXHIBIT 1 



Balance Sheet as of June 30, 1959 



ASSETS 

Cash in banks and on hand $ 38,629.16 

Accounts Receivable 

Receivable from lot purchasers $607,934.20 

Reserves withheld by bank 2,967.25 610,901.45 

Cash Advances to Salesmen 23,529.89 

Cash surrender value of insurance on life of employee 1,568.10 



Fixed Assets 



Reserve of 
Cost Depreciation 



Automotive equipment $ 6,471.41 $ 5,400.41 

Buildings 13,777.60 4,810.30 

Cemetery equipment 16,894.47 8,227.88 

Cemetery improvements 90,718.29 11,187.57 

Office equipment 18,026.56 13,700.67 

$145,888.33 $ 43,326.83 102,561.50 

Cemetery development 272,006.99 

Supplies and prepaid expenses 3,713.50 

Total assets (Note A) $1,052,910.59 



LIABILITIES AND DEFICIT 

Liabilities 

Accounts payable $ 7,648.66 

Customers' credit balances 967.65 

Reserves for payroll taxes 3,808.00 

Due Endowment Care Fund 

On funds collected $ 12,271.57 

On charges uncollected 134,896.04 147,167.61 

Proceeds of lot sales due land- holding 

certificate holders 1,099,111.96 

Accrued Liabilities 

Salesmen's Commissions $48,034.72 

Other expenses 4,645.74 52,680.46 

Total liabilities $1,311,420.34 

Deficit (258,509.75 ) 

Total liabilities and deficit . . . $1,052,910.59 



Note A : In 1892, the corporation purchased land for use as a cemetery site under the 
terms of a special francise granted by the City of Glendale, California, which provided that 
one-half of the proceeds of sales of the use of lots and plots be paid as the purchase price. 
Because this amount is indeterminate the value of the land and the related liability have not 
been included in the balance sheet. 



399 



EXHIBIT 2 



Redwood Memorial Park Contrasted with a Typical 
Graveyard 




(a) Redwood Memorial Park 







I' 



.HPI'lf •;?«*->- 



MiU 







*$ > * 



(b) A Typical Graveyard 







400 



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401 



EXHIBIT 4 



Accounts Receivable from Lot Purchasers 
As of June 30, 1960 



Past due $147,818.72 

Due within one year 231,449.00 

Due within two years 157,608,00 

Due within three years 75,905.65 

Due after three years 27,028.91 

Total $639,810.28 

Note : All accounts receivable are secured by signature notes. There were no 
credit balances in the accounts receivable ledger. 






402 



EXHIBIT 5 



Detail of Development Cost Account to June 30, 1959 













Effective 












Number of 




Total Spaces 


Less Unsal- 


Net Spaces 


Estimated % of 


Completed 


Section 


or | Estates | in 


able Spaces 


Available 


Completion as 


Spaces 


Number 


Section* 


in Section 
204 


1-2 


of 6/30/59 
100 


(3 x4) 


1 


14,479 


14,275 


14,275 


2 











- 





3 


10,294 


200 


10,094 


95 


9,589 


4 


6,598 


144 


6,454 


55 


3,550 


5 


13,612 


268 


13,344 


80 


10,675 


6 


2,278 


19 


2,259 


90 


2,033 


7 


na 





m 


65 


EH 


8 


682 


7 


675 


100 


675 


9 


9,606 


92 


9,514 


98 


9,324 


10 


19,240 


180 


19,060 


25 


4,765 



Totals 



76,869 



1,114 



75,755 



54,938 



♦There are approximately 1,000 spaces to an acre of land. 
Prepared by Mr. Martin, accountant for Redwood Memorial Park. 



cont'd 



403 



EXHIBIT 5, cont'd 



10 



11 



Total Costs 

Charged to 

6/30/59 



Cost Per 
Space 
(6+ 5) 



Total Spaces 
Sold to 
6/30/59 



$583,882.57 
311,875.58 



Total Cost 

of Spaces 

Sold to Date 

(7 x8) 



Total Cost 

Allocated to 

Spaces Sold 

Up to 6/30/58 



Cost of 

Spaces Sold 

Current Year 

9-10 



$127,647.05 


$ 8.942 


9,004 


$ 80,513.77 


$ 76,178.13 


$ 4,335.64 


1,960.00 


- 





- 





- 


65,684.65 


6.850 


6,856 


46,963.60 


47,826.19 


( 862.59) 


64,666.80 


18.216 


2,138 


38,945.81 


42,712.00 


( 3,766.19) 


98,423.50 


9.220 


2,026 


18,679.72 


14,542.16 


4,137.56 


11,760.91 


5.785 


1,941 


11,228.68 


9,088.89 


2,139.79 


4,446.00 


85.500 


El 


2,907.00 


3,130.29 


( 223.29) 


6,468.10 


9.582 


647 


6,199.55 


4,219.67 


1,979.88 


100,568.66 


10.786 


5,205 


56,178.13 


51,901.20 


4,276.93 


102,256.90 


21.460 


2,342 


50,259.32 


13,578.00 


36,681.32 



30,193 



$311,875.58 $263,176.53 



$272,006.99 To 6-30-59 Balance Sheet 



$48,699.05 



404 



EXHIBIT 6 



Detail of Section Development During Fiscal Year 
Ended June 30, 1960 



Section 
Number 


Total Spaces 

or | Estates | 

in Section 

14,479 


Less 

Unsalable 

Spaces in 

Section 

204 


Net 

Spaces 

Available 

1-2 


Estimated 

% of 
Completion 

as of 
6/30/60 

100 


Current Costs 
Charged to 

Section Dur- 
ing F.Y.E. 
6/30/60 

$ 206.63 


Total Spaces 

Sold* in the 

F.Y.E. 

6/30/60 


1 


14,275 


310 


2 











- 


1,441.72 





3 


10,294 


200 


10,094 


90 


1,216.87 


229 


4 


6,585 


144 


6,441 


65 


3,487.10 


878 


5 


13,612 


268 


13,344 


90 


2,675.00 


121 


6 

7 


2,278 


19 



2,259 


95 
78 


836.20 
2,680.00 


62 




8 


682 


7 


675 


100 








9 


9,606 


92 


9,514 


95 


2,157.65 


10 


10 


19,240 


286 


18,954 


40 


13,816.20 


844 


11 


8,300 


62 


8,238 


15 


2,870.13 


22 


Totals 


85,156 


1,282 


83,874 


- 


$31,387.50 


2,483 



*These figures represented gross lot sales and had not been adjusted for sales cancel- 
lations which took place during the year. 



405 



EXHIBIT 7 



Expense Account Summary 
for the Fiscal Year Ending June 30, 1960 

Part 1 — General & Office * 

Advertising— death notices, billboard, brochures $ 7,088.30 

Directors' fees 1,200.00 

Employees' insurance & pension fund contribution 7,419.76 

General administrative expenses 3,145.88 

General expense of servicing salesmen— home office expense . . . 4,223.29 

Insurance on lives of lot owners 2,290.19 

Insurance— all other 621.15 

Office supplies and expense 7,767.21 

Payroll taxes 4,562.36 

Professional services 5,050.00 

Public relations and sales promotion 9,736.68 

Rent and light 10,474.79 

Salaries— executive 13,031.18 

Salaries— office 46,692.68 

Telephone & telegraph 5,351.65 

Total $128,655.10 



Part 2— Cemetery Maintenance & Development Costs * 
( Exclusive of the Direct Costs Shown in Exhibit 6 ) 

Cemetery supplies and expense— included the cost of crypts, 

grass-seed, fertilizer, and cement used during the year $11,515.00 

Equipment operation and maintenance— repairs, gasoline, etc. . . 4,849.13 

Heat, light, and power 1,144.40 

Insurance— this included the premium on a policy that covered 

the park superintendent 3,026.90 

Payroll taxes 2,013.74 

Salaries and wages— superintendent 15,420.00 

Salaries and wages— general maintenance 61,109.64 

Telephone and telegraph 838.83 

Total $99,917.64 



*A11 expense items had been calculated under the accrual concept and thus had 
been adjusted for unused supplies and prepaid expenses of $3,773.59, accrued 
payroll taxes not paid as of June 30, 1960 of $3,150.08, and accrued miscellaneous 
expenses of $13,657.07 not paid as of June 30, 1960. 

The Cash Surrender value of the life insurance contract increased by $1,400 dur- 
ing the year. 



406 



EXHIBIT 7, cont'd 



Part 3— Schedule of Fixed Assets 



Original 
Cost 
Automotive Equipment— Trucks 

As of June 30, 1959. . . $ 6,471.41 
Purchased 1960 
Chevrolet pick-up 
truck for general 
cemetery use De- 
cember 30, 1959. . . 

Buildings 

Temporary sales office 
Garage and addition . . 

Cemetery Equipment 
As of June 30, 1959. . . 
Purchased Ford trac- 
tor and gang cutter 
Oct. 15, 1959 .... 

Cemetery Improvements 
As of June 30, 1959. . . 

Office Equipment 

As of June 30, 1959. . . 
Purchased new desks, 

adding machines, 

and typewriters 

February 1, 1960 . . 



Accumulated Depreciation 

Depreciation Scheduled for Estimated 
to 6/30/59 F.Y. 1960 Life 

$ 5,400.41 $ 486.00 Various 



2,850.00 




285.000 


5 years 


4,967.00 
8,810.60 


2,751.26 
2,059.04 


672.00 
742.08 


Various 
Various 


16,894.47 


8,227.88 


1,629.42 


Various 


1,095.35 




82.15 


10 years 


90,718.29 


11,187.57 


1,814.37 


50 years 


18,026.56 


13,700.67 


1,300.08 


10 years 



1,295.70 



54.00 10 years 



Total $151,129.38 $43,326.83 $7,065.10 



Note : No depreciation had been included in the above expense summaries. 
The cemetery equipment consisted of tractors, drag rakes, cutters, 

grave diggers, and sprayers used both to maintain and to develop 

the cemetery land. 
The cemetery improvements were composed of the entrance archway, 

lakes, and the Chapel in the Redwoods. 
The straight line method of depreciation was used in depreciating all 

fixed assets. 



407 



CASE 50 



Harvard 
Law Review 







n May 20, 1958, the treasurer of the Harvard 
Law Review, Mr. Nat Lewin, was faced with 
the problem of making a major policy recommendation. A year earlier, 
the trustees of the Harvard Law Review Association authorized the re- 
printing of a substantial number of issues in Volumes 41-67 (1928-1954). 
The Board declined, at that time, to take action on the question of 
reprinting Volumes 1-40 (1887-1927) in order to allow the treasurer 
time for further investigation. In the morning's mail, Mr. Lewin received 
confirmation that the Board wished to receive his recommendation at its 
next quarterly meeting on July 15. 

The Harvard Law Review Association was founded in 1887 as an 
organization of students at the Harvard University Law School interested 
primarily in the publication of a journal of writings of interest to the legal 
profession. The Law Review grew steadily over the years and became 
recognized as a leading publication in the field of law. Although the fa- 
culty of the Law School showed considerable interest in the Review, 
and lent a great deal of consultive support, the organization developed 
as one managed primarily by students. 

The offices of the Harvard Law Review were located in Gannett House, 
on the campus of the Harvard Law School. That building, as well as 
extensive storage space in nearby buildings, was provided without charge 
by the University and served as the base of operations for the officers 
and staff of the Review. Although the offices and storage areas were not 
sumptuously furnished, they were adequate for the needs of the Review 

408 



Harvard Law Review 409 

in 1958 *; in May, 1959, additional office space for the use of student 
editors was to be constructed (by the University) in the unused attic 
of Gannett House. 

The president and the treasurer of the Harvard Law Review were the 
two principal administrative officers, and they supervised all aspects of 
the journal's operation. In addition to handling business matters, the 
treasurer also participated in the editorial supervision of the journal. He 
spent many hours reading copy, reviewing printer's proofs, and checking 
for accuracy, consistency, and editorial acceptability. There were sharply 
divided opinions about the proper role of the treasurer; some past treas- 
urers felt that he should be almost exclusively a business manager. Others 
adopted virtually an opposite view and considered the business side of 
the venture as a necessary, but unwelcome, intrusion into the time that 
was available for matters of law (see Exhibit 1). 

In addition to the students who served as president and treasurer, 
there were some fifty student editors and four paid employees. The 
student editors were chosen on the basis of academic achievement, usually 
at the end of their first year at the Law School, and the president and 
treasurer were chosen at the end of their second year by vote of the 
student editors. Thus the formal administration of the Review changed 
annually, and the paid staff of four served as the connecting link between 
successive administrations. 

The paid employees were: a business office manager; a business office 
secretary; an editorial secretary who worked mostly for the president; 
and a student part-time worker who handled mail orders and cared for 
the stockrooms. 

The Harvard Law Review was published monthly, eight issues a year, 
from November through June. Its contents were fairly uniform from 
month to month except for the inclusion of a special developments report 
in two or three issues a year. Normally, an issue comprised several major 
articles contributed by authors outside of the student staff, reviews of 
cases and books that were expected to be of interest to the legal profes- 
sion, and several notes on matters of general interest, prepared by student 
editors. There was some advertising copy in each issue, but little em- 
phasis had been placed on the solicitation of advertising contracts. If 
the treasurer had an opportunity to sell space he did, but most of the 
advertising in the Review had not been solicited directly. 

THE "LAW REVIEW" PRODUCT LINE 

Over the years, the Board of Trustees developed a general policy that 



1 The 1957 reprinting program, however, consumed a good bit of space that would 
otherwise have been free for use in later years. 



410 Harvard Law Review 

determined what the Review would sell and in what forms the publica- 
tion would be offered. Basically, the offerings of the Review were referred 
to either as issues, volumes, or sets. The term "issue" was used to designate 
a single monthly copy of the Review; all eight issues from a publication 
year comprised a "volume," and a "set" referred to any one of several 
combinations of volumes that were regularly offered for sale. The major 
"product" was the current issue of the Harvard Law Review, with a 
mailing list of approximately 8,100 names; 2 hence, much of the day- 
to-day effort was consumed in handling current subscription business. 

Current Subscription Business. Mailing of current issues to subscribers 
was done by the printer, but all bookkeeping and record maintenance 
was taken care of by the office staff. A majority of the subscriptions ran 
on a normal volume-year (November through June) and were usually 
billed after the first issue was mailed in November. A number of the 
subscriptions, however, were originally placed in months within the vol- 
ume-year and required separate processing depending on the anniversary 
month. Mr. Lewin was not sure whether this created a special problem 
or whether it was a convenient way of staggering the billing workload. 
Because subscriptions were considered to renew automatically in the 
absence of express instructions to the contrary, mailing lists at the print- 
er's office required no special handling (see Exhibit 2 for circulation 
statistics ) . 

Nonsubscription Business. Frequently, persons who did not subscribe 
to the Review wished to obtain single copies, or regular subscribers 
wished additional copies. Since the Review stocked reprints of relatively 
few individual articles, most requests for single items were filled by mail- 
ing single issues from the current or past volumes. This mailing was 
handled from Gannett House and was the responsibility of the part-time 
employee. Following is a list of offerings other than regular one-year 
subscriptions (see Exhibit 2 for price information). 

1. Single Issues from Current Volume: Volumes were numbered an- 
nually (1957-1958 year was Volume 71), and extra copies from the cur- 
rent volume were mailed from the offices in Gannett House as orders 
were received. 

2. Single Issues from Back Volumes: Individual issues were mailed, 
on request, from Gannett House. The basic inventory of back issues was 
maintained in the stockrooms in the basement of Gannett House and 
in neighboring buildings; a working inventory of back issues was kept 
in the offices. 

3. Complete Back Volumes: The Review offered full volumes (each 
comprising the eight separate issues from a publication year) in either 



2 Approximately 15 per cent of the subscriptions were sold through agents who 
were given a 15 per cent discount off the regular subscription price. 



Harvard Law Review 411 

bound or unbound form. Purchase of an unbound volume was the equiva- 
lent of buying eight separate back issues. 

4. Bound Sets: Frequently, requests were received for a full set— or 
some portion of a full set— of back volumes of the Review. In 1958, a full 
set was made up of Volumes 1 through 70, together with a three-volume 
index (also available separately), and a short set was made up of Vol- 
umes 51 through 70 with a two-volume index. 

5. Other Offerings: From time to time, articles appearing in the Review 
attracted sufficient attention to justify separate printing. The Review 
carried a stock of its more popular individual articles and also compiled 
several collections of articles which were stocked and sold on request. 
Sales of these items brought in more than $10,000 during the year ended 
June 30, 1957. 

Subscribers to the Harvard Law Review sometimes wished to have 
their personal copies of the journal bound and could do so through the 
Review. Also, indexes to past volumes were cumulated in standard form 
and sold as orders were received. 



PRINTING THE REVIEW 

The printing and publishing work for the Harvard Law Review was 
done commercially— printing and storage of printing plates at the Harvard 
University Printing Office, and binding and mailing by a local firm. 

Approximately 1,100 copies of each issue were printed over and above 
the requirements of the regular subscriber lists. Of these, 400 were stored 
in inventory unbound; the remainder were bound and sold as individual 
issues. A portion of the unbound issues were bound into full volumes at 
the end of the year, and between 75 and 100 of these were usually sold 
within the next year. Thereafter, about 25 volumes a year were sold as 
part of bound set sales. If this pattern continued, Lewin felt that the 
400 issue over-run for binding into volumes would be sufficient for about 
fifteen years. Lewin believed that this was inadequate and that the over- 
run should be increased to allow binding of at least 600 volumes each 
year. 

The cost of printing and publication was a matter of continuing con- 
cern to the treasurer and his staff. Exhibit 3 summarizes the printing 
requirements for the three latest Volumes (69-71), and Exhibit 4 con- 
tains an analysis of the unit publication expense associated therewith. 
The following comments on the individual elements of cost are sig- 
nificant and relate to the analysis of total publications expenses in Ex- 
hibit 5. 

Composition: Composition cost varied between $5.85 and $9.10 per page, 
depending upon format and size of type. The average cost per page 



412 Harvard Law Review 

was about $7.00; this was the one-time cost of preparing an issue for 
the presses. 

Presswork: Presswork charges varied with the length of the issue and 
with the number of copies that were printed. An increase in run 
from 8,800 to 9,200 copies, for instance, cost $20 for a 192-page issue. 
Mr. Lewin felt that overprinting was the only practicable way of 
maintaining an inventory of back issues. Presswork cost about $25 
for an additional 500 copies printed in the original run. The same 
500 copies cost about $350 for presswork if it later became necessary 
to reprint the issue. 

Alteration Charges: Lewin referred to this as "the price of changing our 
minds after copy is sent to press." He pointed out that prestige 
requirements were so great that, in striving for editorial perfection, 
the Association had to be willing to underwrite the costs of altera- 
tions and changes. 

Paper: Paper was charged to the Review by the Harvard University 
Printing Office, and the amount of the charge was governed by the 
number of pages per copy and the number of copies printed. 

Binding and Mailing: The reduction in cost for Volume 71 was due to 
a change in the firm that handled the binding and mailing. How- 
ever, transportation costs of $75 per issue, made necessary by the 
change, and postage of $65 per issue were not included in the figures 
given. Mr. Lewin observed that, "If overprinted copies are folded, 
gathered, and bound with the original run, the cost is $.01 each, 
but printing and binding of advertising is wasted. 3 If done by hand 

REPRINTING THE EARLY VOLUMES 

At the time he received notice of the wishes of the Board, Mr. Lewin 
was aware that a decision on the question of reprinting Volumes 1 
through 40 would have major policy implications. The problem of decid- 
ing on the advisability of a reprinting program arose directly out of long- 
standing policy to make available both sets and volumes commencing 
with Volume 1; further, the problem had become more acute as the 
stock of several of the early volumes was depleted, making it impossible 
to provide full service. Then, arising out of the pressures of the existing 
policy, and dependent upon the interrelated factors of demand, inventory 
levels, costs, and selling price, the task of answering the reprinting ques- 
tion became Le win's major concern. 

Demand for Back Volumes. Although the Review sold back copies in 
three forms (bound sets, single volumes, and single issues), Lewin con- 

3 In subsequent reprinting, no advertising copy would be run. 
later, however, the cost is $.31 each." 



Harvard Law Review 413 

eluded that only sales of bound sets were of significance insofar as issues 
prior to Volume 40 were concerned. His conclusion was based on informa- 
tion in his records which indicated that in the period from May 1956 
through May 1958, 67 single back-issues and 17 single back-volumes 
were sold. Thus, the crucial focus was on the number of bound volumes 
in sets that would be needed. Sales of bound sets that included Volumes 
1-40 were as follows for the period from 1947 through 1957: 



1947-1948 


22 


1952-1953 


25 


1948-1949 


34 


1953-1954 


11 


1949-1950 


34 


1954-1955 


20 


1950-1951 


24 


1955-1956 


15 


1951-1952 


34 


1956-1957 


34 



On the basis of past demand, Lewin predicted that the Review would 
need from 15 to 25 copies of each volume each year if the policy of 
offering full sets were continued. 

Inventory. According to past policy, about 400 copies of each issue 
were placed in inventory unbound. The inventory data adjusted to April 
30 (Exhibit 3) indicated that for Volumes 69-71 a sizable stock was 
on hand. Further, the reprinting program that had been approved in 
1957 brought the inventory of Volumes 41-67 up to 500 copies with 100 
copies bound. Mr. Lewin was sure that this represented a good two 
years' supply of bound volumes. After that time, some binding would 
be required, but not much. Since the binding cost per volume would 
be the same regardless of number of volumes bound, he felt that he 
was under no immediate pressure to enter into a long-range binding 
program. 

When he reviewed the inventory statistics on Volumes 1-40, however, 
the treasurer faced the specific problem on which he must report to the 
Board. He analyzed the adequacy of the inventory of early volumes in 
consideration of his estimate of sales of from 15 to 25 sets a year. On 
that basis, he divided the inventory into categories to see which volumes 
were in less than one year's supply, which were in one to two years' 
supply, and which were in more than two years' supply. The data that 
Lewin developed, showing both quantity and category, are summarized 
in Exhibit 6. 

Cost of Reprinting. Reprinting in quantities of 500 units, printing and 
binding a full set of the Review at 1958 costs would be approximately: 

Volumes 1-10 $ 45.00 (average $4.50 per unit) 

Volumes 11-40 167.50 (average $5.25 per unit) 

Volumes 41-70 180.00 (average $6.00 per unit) 

One full set $392.50 (average $5.60 per unit) 



4 The abnormal decline in sales of sets in the 1956-1957 year was a result of in- 
ventory shortages which made it impossible to ship complete sets (see Exhibit 6). 



414 Harvard Law Review 

The difference in cost for different volumes was largely a function of 
the size of the volume. Over time, the Review had increased in size and, 
as a result, the costs that vary with size caused variations in per-volume 
costs of reprinting. Paper cost, for instance, was directly related to num- 
ber of pages per volume and was greater for later volumes than for 
earlier ones. Some costs, on the other hand, were constant per volume 
regardless of size. Binding of the individual volumes did not vary with 
the size of the volume and had been agreed upon at the rate of $2.25 
per unit. 

Using the data that he developed on current inventory levels, Mr. 
Lewin assigned priority to each volume if reprinting were to be under- 
taken. Recalling that there had been talk of offering a new short set 
commencing with Volume 26, Lewin compiled the costs for full sets and 
for short sets. His projections anticipated a three-year cost of $65,250 
to keep Volumes 1-40 in full supply, and $25,875 to maintain a full stock 
of Volumes 26-40 ( Exhibit 7 ) . His analysis was based on the past policy 
of reprinting 500 copies of each issue and of binding 100 copies at the 
time of printing. He reported that a reduction from 500 to 200 reprinted 
copies would save only 10 per cent of the cost and a reduction down to 
100 copies would save only another 7y 2 per cent of the cost, exclusive 
of binding cost. 

Selling Prices. In order to compare anticipated revenues with the cost 
of reprinted sets, Lewin detailed the history of the selling price of the 
complete bound set as follows: 

Selling Price 
Per Set Per Volume 

1940 Volumes 1-52 $110 $2.10 

1945 Volumes 1-55 125 2.30 

1948 Volumes 1-60 225 3.75 

1952 Volumes 1-65 300 4.60 

1953 Volumes 1-65 325 5.00 

1957 Volumes 1-65 400 6.15 

1958 Volumes 1-70 * 465 6.65 

* Effective November, 1958. 

To Mr. Lewin, it was clear that the low original cost of printing the 
early volumes was a major factor that made it possible to carry the bound 
volume business at 1958 selling prices. To be sure, the price of $465 
( Volumes 1 through 70 ) planned for November would increase the mar- 
gin somewhat. Even so, Lewin feared that a decision to enter into a 
major reprinting program would cause the Board to question the ade- 
quacy of the full-set selling price. 



Harvard Law Review 415 



FINANCIAL REPORTS 

The Balance Sheets and Profit and Loss Statements (Exhibits 8 and 
9), and the Analysis of Publication Costs per Copy (Exhibit 4) were 
the primary information statements that were available to the officers 
and the Board. Mr. Lewin was uncertain of the value of these statements 
as they had been prepared in the past. He wanted to study this question 
before making any recommendations that would be based on the reported 
data. 

Looking at the Profit and Loss Statement for Volume 70, Mr. Lewin 
felt that it might be more realistic to divide the presentation into an 
analysis of (1) operating profit, (2) ordinary investment income, and 
(3) capital gains. Such an approach would mean that the operating profit 
for Volume 70 would be the "Net Operating Profit" as shown, plus 
"Discount Earned" and "Miscellaneous Income," and less the "Loss on 
Contributors' Reprints." The ordinary investment income would be the 
dividend and interest income amounts, less the expenses of the graduate 
treasurer. Then, Volume 70 income would be classified as follows: 

Operating profit $2,204.32 

Ordinary investment income 4,314.91 

Capital gain 1,287.03 

Net profit $7,806.26 

Cost Allocation. More important, Mr. Lewin believed, was the question 
of proper allocation of costs between those attributable to current pub- 
lishing and those attributable to the cost of sales of other volumes and 
materials. It was not unlikely that the Association would always expect 
to subsidize the business in back volumes. Mr. Lewin expressed his con- 
cern by saying, "Rational decision-making demands that we at least 
know the extent of the subsidy— and the Profit and Loss Statement is 
in many ways misleading on this question." 

In the past, at least two board members had questioned the soundness 
of continuing the overprinting program at all. They reasoned that the 
prestige value of the back-volume offering was hardly worthwhile in 
consideration of the costs involved in printing to meet long-term require- 
ments and carrying ever-increasing inventories. Each year they attacked 
the back-volume policy; as a counter-plan they proposed (at the 1957 
meeting) that an amount equivalent to the annual cost of back- volume 
printing be devoted instead to scholarships, professional educational sem- 
inars, or some other comparable activity. Although the soundness of 
their reasoning was not a matter for Lewin to evaluate at the moment, 
he was convinced that the Board would be ill-advised to base its decision 
on the misleading classification of income and expenses in the operating 
statements. 



416 Harvard Law Review 

For one thing, he pointed out, the Review was not separately billed 
by the Printing Office for the cost of electroplating; this was included in 
the total composition cost. For many years prior to 1958, the practice 
was to capitalize 5 per cent of the composition charge and to depreciate 
it over 16% years. The 1958 plating cost, however, was probably closer 
to 20 per cent of the composition charge. The depreciation charge on 
capitalized electroplating cost was combined with depreciation on other 
assets and deducted from income as part of the general and administra- 
tive expenses in the Profit and Loss Statement. 

Were it not necessary to preserve the plates for future reprinting, it 
would not have been necessary to incur the charge for electroplating. 
Lewin believed that the depreciation charge on the plates, calculated at 
a 6 per cent annual rate, should not be charged at all against the current 
issue. As for the amount of the electroplating cost to be charged off an- 
nually, Lewin said, "The supposed useful life is, of course, entirely ar- 
bitrary. Although I have no particular objection to the 16% years, I would 
like to see the cost capitalized realistically. And if this should be done, 
I would like to see the depreciable life shortened so that we will not 
have to wait 17 years before the total annual depreciation figure is 
realistic." 

Another thing that bothered the treasurer was that one of the costs 
of supplying back issues of a periodical was the necessity of an ever- 
increasing inventory. Roughly $5,000 of Volume 70 was added to in- 
ventory simply because it became necessary to stock eight more issues of 
the Review. "Perhaps," he mused, "this is properly a cost of the increased 
sales we might expect because we now stock 560 instead of 552 separate 
issues. But I suspect that our use of an inventory system of accounting 
leads us, under the circumstances, to be somewhat over-optimistic about 
our financial position. Perhaps it would be helpful to have, as a sup- 
plement to the Profit and Loss Statement, a short-form statement of our 
cash expenditures and cash income." 

Mr. Lewin also noted that the back inventory was expensive to main- 
tain. Costs included insurance on the entire inventory, shelving, employee 
time in processing and filling orders, casual labor for transfers to the 
bindery or to the working inventory in the main offices, labor for physical 
counts, and labor and boxes for packing and storing new accretions from 
current overprint or reprinting. He felt that these costs should be re- 
flected as part of the cost of handling back-issue sales. For instance, 
certainly the cost of insuring and storing the plates should be charged 
against the sales of other volumes and materials rather than to general 
expense. And, in fairness, about half of the annual salary expense was 
directly attributable to the back-order business since the part-time em- 
ployee and the office clerk had been hired principally because of the 
demands of the back- volume business. 



Harvard Law Review 417 

Unit Publication Costs. Whereas the problems of income statement 
presentation might be solved by a modification in the form of the state- 
ments, a problem of greater concern was the fairness of the calculation 
of the publication cost per copy (Exhibit 4). The publication cost per 
copy was used in determining (1) the value of transfers to inventory 
from current year publications, (2) the cost of current publications, by 
subtracting inventory transfers, and ( 3 ) the cost of future sales of back- 
volumes. Obviously, the influence of this calculation would be wide- 
spread. 

There were three separate quantity figures that were used in deter- 
mining the value per copy of publication work. The first stage of publica- 
tion included all work through the printing, folding, and gathering to- 
gether the pages of an issue, but preceding the actual binding process. 
At this point all copies ( those to be retained unbound, those to be bound 
and held for single copy sales, and those to be mailed to subscribers) 
had passed through a common process (70,400 units for Volume 70, 
per Exhibit 3). In the next stage of publication, the units to be held in 
stock unbound (pending binding into full volumes at the end of the 
year ) would be eliminated and only the balance would be bound ( 67,200 
for Volume 70, per Exhibit 3). And, finally, the bound issues that were 
to be stocked for sale as individual copies did not go through the mailing 
process and, thus, bore no share of the cost of addressing and mailing. 
The number of subscription copies for the year was used to determine 
per unit cost of addressing and mailing (60,200 for Volume 70, per Ex- 
hibit 3). 

The cost per unit figure, at any given stage, was an average cost per 
unit. Considering this, Mr. Lewin indicated that his earlier reference to 
the subsidization of the back-volume business by current operations was 
really only part of the picture. He wondered if the shoe might not really 
be on the other foot. That is, perhaps the method of calculating unit 
costs, and then cost of sales and value of inventory, was really forcing 
the back-volume business to cover unfavorable performance in the cur- 
rent operations. 

His reasoning was based upon consideration of incremental rather than 
average costs. A common characteristic of publishing costs is that the 
charge for added copies is only a fraction of the cost of original work. 
In its policy, the Board of the Review had recognized this by providing 
for a sizable initial overprint. As a matter of fact, Mr. Lewin felt that 
more advantage ought to be taken of the savings on first-run overprinting. 
At the same time, he felt that the size of the overprint should not be per- 
mitted to determine the cost of current operations. This, essentially, was 
exactly what was taking place. 

If the Review were to engage in no back- volume business, and were 
to print only current material, a greater part of the cost of publishing 



418 Harvard Law Review 

would have to be borne by the current printings. As soon as an overprint 
was added, the method of cost calculation that was used by the Review 
averaged all costs over all copies. The net effect of this was to remove 
from current operations a substantial part of costs that would have to be 
borne regardless, and to charge them to the value of the copies over- 
printed. The increased cost of inventory units served, first, to reduce the 
profits made on back-volume business, and second, to make the profits 
of the current operation appear higher than they would if current business 
had to absorb full costs without benefit of overprint. 

Mr. Lewin was not sure how much difference a change in the method 
of calculating per unit costs would make; neither was he sure at what 
point the benefit of over-run, as such, commenced. Clearly, the Review 
had to print to meet subscription needs. It was also reasonable to expect 
that at least a part of the single-issue business would fall into the category 
of current operations. There did not seem to be much argument, however, 
to support a contention that the 400 unbound units, stocked specifically 
for back-volume business, could realistically be considered part of the 
current operations. 

As he thought about devising a plan of action to present to the Board 
of Trustees, Mr. Lewin realized that his problem involved much more 
than determining whether he thought that an extensive program of re- 
printing should be planned. He felt that an intelligent recommendation 
should deal with the questions of income and cost determination as well. 
As he viewed the questions that his investigation had turned up, he 
seriously considered asking the Board for another extension for further 
investigation, and at the same time for authorization to hire a second-year 
Business School student as business manager. 



EXHIBIT 1 



Excerpts from Various Treasurers' Reports 



"The treasurer in the past few years has been responsible for proofreading 
the entire issue at one proof stage or another, for answering Blue Book questions, 
for assigning work to the Review 's 50-odd editors, for measuring galleys, and 
for doing a good deal of the collating in addition to duties with respect to the bus- 
iness aspects of the Review's operations." (May, 1956) 



". . . I do not think, however, that the conclusion drawn by my predecessor, 
that these functions are therefore undesirable, necessarily follows. In the first 
place, the treasurer is a law student and has presumably chosen the law as his 
career. The Harvard Law Review monopolizes the time of its editors, particularly 
of its officers, and allows little extra- Review study. I think it would be unfair and 
improper to isolate such a man from the law in favor of business matters." 
(June, 1957) 



". . . the job of treasurer, as organized during Volume 70, was too big to be 
done well by ordinary mortals. The number of surprises which the auditor's re- 
port* revealed to me confirms my belief that a greater portion of the treasurer's 
time should be spent on business matters." (June, 1957) 



"Several other solutions are possible and should be considered. One would be 
the creation of an office of assistant treasurer; this would tend, however, to 
create an undesirable hierarchy on the board of officers and would separate the 
functions which seem to be integral. Another would be performance of the routine 
business tasks by a paid employee, who would be subject to the supervision of the 
treasurer and the policy decisions of the president and treasurer. Perhaps such 
an employee could be hired on a part-time basis from among the students at the 
Business School. On the other hand, the treasurer might be required to remain 
at Gannett House during the summer, as the president is at the present time. The 
second of these possibilities seems the best to me. However, it is hoped that fu- 
ture treasurers may find further and more satisfactory compromises." (May, 
1958) 

*The Constitution of the Association required that the books and records of 
the Harvard Law Review Association be audited annually by a certified public 
accountant and that the reports of the public auditor should be presented to the 
Board of the Association. 

Sources : Treasurer's Interim Report, May 1956; Treasurer's Final Report as 
of June 30, 1957; and Treasurer's Interim Report, May 1958. 



419 



EXHIBIT 2 



Circulation and Sales Volume Data 



1955-1956 1956-1957 1957-1958 

(Volume 69) (Volume 70) (Volume 71) 

Quantity Rate Quantity Rate Quantity Rate 

Subscriptions: 

Regular 5,429 $ 7.50 5,292 $ 7.50 5,747 $ 8.50 

Postgraduate:* 296 5.00 311 312 

1st Year P.G 5.00 5.00 6.00 

2nd Year P.G 6.00 6.00 6.00 

Law School students 628 4.00 601 4.00 571 4.00 

Agents 987 6.37 1,095 6.37 1,272 7.22 

Complimentary 237 228 251 

Total 7,577 7,527 8,153 

Single Issues 

Current volume 1,752 1.25 1,887 1.25 2,081 1.50 

Back volumes 1.50 1.50 2.00 

Single Bound Volume 208 10.00 299 10.00 239 11.00 

Bound Sets, w/index:| 

Volumes 1-65 15 $400.00 3 $400.00 - $400.00 

Volumes 1-70 - - - - - 465.00J 

Volumes 51-65 6 $140.00 10 $140.00 

Volumes 51-70 - - - - - $180.00 

Indexes (bound): 

Volumes 1-50 8 $ 7.50 8 $ 7.50 6 $ 7.50 

Volumes 51-65 82 7.50 52 7.50 21 

Volumes 1-65 - 14.00 - 14.00 

Volumes 66-70 - - - - 746 $ 5.50 

Volumes 1-70 (3 vol.) - - - - - 19.00 

Volumes 51-70 (2 vol.) .... - - - - - 12.00 

♦Reduced rate offered for first two years following graduation from Law School. 

tCredit allowed for each volume not taken: Volumes 1-40, $4.00 credit 

Volumes 41-50, $5.00 credit 

Volumes 51-70, $6.00 credit 

{Available commencing with Volume 72 (November 1958). 

Source: Company records. 



420 



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EXHIBIT 4 Comparative Publication Costs— Volumes 69 and 70 

Costs per Copy 
Volume 70 Volume 69 

Composition cost-Reading matter $0.1976 $0.1607 

Printing charges 0.0961 0.0966 

Text paper* 0.1387 0.1082 

Editorial expense! 0.0339 0.0275 

Cost of unbound copies $0.4663 $0.3930 

Composition cost— Advertising matter 0.0093 0.0077 

Binding charges 0.1061 0.1036 

Cover paper* 0.0088 0.0077 

Cost of bound copies $0.5905 $0.5120 

Addressing and mailing 0.0593 0.0579 

Cost of subscription copies $0.6498 $0.5699 

*For Volume 69, cover-paper cost $.0077 per issue bound; for Volume 70, 
cover-paper cost $.0088 per issue bound. The balance of the paper expense was 
for text paper. 

f 50% of total editorial expense (alteration charges and expenses of student ed- 
itors) was used to calculate unit cost. 

Source : Treasurer's Report, Volume 70 as based on original data now in Ex- 
hibits 3 and 8. 



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423 



EXHIBIT 6 


Analysis 


of Inventory, Volumes 1 
April 30, 1958 

Supply Level 

(1 to 2 years) 

Volume Quantity 


-40* 

Supply 
(more thai 
Volume 




Supply Level 

(less than 1 year) 

Volume Quantity 


Level 
i 2 years) 
Quantity 


3 


1 


1 


35 


26 


70 


4 


8 


2 


28 


27 


75 


6 


3 


5 


21 


28 


69 


7 


12 


8 


18 


29 


68 


9 





11 


15 


30 


66 


10 





12 


34 


32 


55 


18 


7 


13 


36 


33 


42 


19 





14 


29 


34 


72 


24 





15 


16 


37 


59 


31 


11 


16 


24 


39 


75 


38 





17 
20 
21 
22 
23 
25 


33 
28 
31 
36 
23 
34 


40 


74 






35 


17 












36 


28 







♦Based on assumption of demand of 15-25 sets annually. 
Source : Company records. 



424 



EXHIBIT 7 



Analysis of Reprinting Requirements— Volumes 1-40 
April 30, 1958 





Fill Stock 
Volumes 1-40 


Fill Stock 
Volumes 26-40 


Summer 1958: 

(Volumes 3, 4, 6, 7, 9, 10, 18, 19, 24, 
31, 38) 






Print, fold, and gather 


$14,250 

2,475 

$16,725 


$ 3,000 

450 

$ 3,450 


Bind 

Total 


Summer 1959: 

(Volumes 1, 2, 5, 8, 11-17, 20-23, 25, 
35, 36) 






Print, fold, and gather 


$25,500 

4,050 

$29,550 


$ 3,000 


Bind 

Total • • * 


450 
$ 3,450 




Summer 1960: 

(Volumes 26-30, 32-34, 37, 39-40) 






Print, fold, and gather 


$16,500 

2,475 

$18,975 

$65,250 

chedule 


$16,500 

2,475 

$18,975 

$25,875 


Bind 

Total 


Total 3-year cost 


Estimated Costs S 


Vol. 1-10 


Vol. 11-40 


Quantity Planned 


Print, fold, and gather $2.25 

Bind 2.25 

Per single volume $4.50 


$3.00 

2.25 

$5.25 


500 
100 


Source: Company records. 







425 



EXHIBIT 8 



Comparative Balance Sheet 
As of June 30, 1956 and 1957 



6/30/56 6/30/57 

Assets "~ (Volume 69) (Volume 70) 

Cash on hand and in banks $ 12,551.58 $ 33,374.69 

Accounts receivable $ 7,685.60 $ 10,276,04 

Less: Allowance for doubt- 
ful accounts 500.00 7,185.60 500.00 9,776.04 

Inventory of published materials . 75,229.47 ^ ~ " 75,506.73 

Funds invested by graduate 

Treasurer 83,159.73 85,076.30 

Fixed assets: 

Electroplates $ 8,113.83 $ 8,524.05 

Less: Dep'n. allowance. . 3,475.17 4,638.66 3,645.85 4,878.20 

Furniture and fixtures $ 3,386.63 $ 3,652.80 

Less: Dep'n. allowance. . 1,085.79 2,300.84 1,308.16 2,344.64 

Office library $ 2,511.87 $ 2,563.65 

Less: Dep'n. allowance. . 1,244.00 1,267.87 1,266.07 1,297.58 

Deferred charges 100.52 66.24 

Total assets $186,434.27 $212,320.42 

Liabilities 

Accounts payable $ 13,627.45 $ 32,018.86 

Deferred income (unexpired 

subscriptions) 4,560.26 4,248.74 

Net worth, July 1st $151,163.25 $168,246.56 

Net gain for year 17,083.31 7,806.26 

Net worth, June 30 168,246.56 

Total liabilities .... $186,434.2 7 $212,320.42 

Source: Treasurer's Report, Volume 70. 



426 




Comparative Income Statements 



Volume 69—8 Issues Volume 70—8 Issues 

7/1/55-6/30/56 7/1/56-6/30/57 

Publication earnings: 

Subscriptions $49,279.98 $50,653.36 

Advertising 4,583.75 4,021.25 

$53,863.73 $54,674.61 

Current publication costs: 

Composition— Advertising ... $ 518.65 $ 623.04 

C omposition- Reading matter . 11,311.36 13,912.65 

Printing 6,801.50 6,764.77 

Binding 6,962.86 7,131.01 

Addressing & mailing 3,502.29 3,570.31 

Paper 8,132.93 10,355.97 

Editorial expense 4,079.58 

$41,309.17 
Less: Additions to stock .... 4,890.02 $36,419.15 5,734.62 $41,395.92 

Current publication earnings ... $17,444.58 $13,278.69 



4,772.79 


$47,130.54 
5,734.62 


$18,463.65 
11,113.25 



Sales of other materials $15,914.64 

Less: inventory cost of sales* . . 8,098.76 . 

Earnings from other sales .... 7,815.88 " 7,350.40 

Gross profit $25,260.46 $20,629.09 

General administrative expenses 16,990.01 18,209.60 

Net operating profit 

Other income: 

Discount & miscellaneous 

income $ 

Dividends and interest .... 
Gain on securities sold . . . 

Other Charges: 

Loss on contributor's 

reprints! 

Graduate treasurer expenses 





$ 8,270.45 




$ 2,419.49 


$ 128.01 
4,277.14 
5,075.53 


9,480.68 
$17,751.13 


$ 366.60 
4,389.91 
1,287.03 


6,043.54 
$ 8,463.03 


$ 592.82 
75.00 


667.82 


$ 581.77 
75.00 


656.77 



Net Profit $17,083.31 $ 7,806.26 

*The "Inventory cost" of back- volume sales is the accumulated per-unit cost for all 
volumes or back-issues sold. 

f Authors of major articles in the Review are extended the courtesy (customary in the 
field) of receiving up to thirty free reprints of the published article. 

Source: Treasurer's Report, Volume 70. 



427 



Topical 
Index 



List of Cases 



7. 
8. 

9. 
10. 

11. 

12. 
13. 
14. 

15. 

16. 
17. 
18. 
19. 
20. 

21. 
22. 



Masters Fuel Oil Company, 9 
Angus Cleaners, 16 
Oliver Optics Company, 20 
Foley Circle Garage, 23 
Morehouse Container Com- 
pany, 27 

H. William Kraft, 33 
Berkshire Country Club, 40 
Pearson's Department Stores, 
Inc., 48 

Brother-in-Law, 60 
Ibbard Chemical Products 
Corporation, 65 
Cole Appliance Stores, Inc., 70 
Jensen Publishing House, 75 
Industrial Uniforms, Inc., 79 
Beldon Woolen Company (A), 
91 

Beldon Woolen Company (B), 
97 

Trumpet Magazine, 103 
Industrial Factors, Inc., 110 
Charles Crowne Company, 120 
Golden Stores, Inc., 133 
R. H. Shay Motor Company, 
Inc., 140 

Showdown at Sunset Pass, 146 
Jordan Marsh Company (A), 
151 



23. Wade Processors, Inc., 161 

24. Pahala Sugar Plantation, Ltd., 
166 

25. Rocky Mountain Construction 
Company, 176 

26. Amos Carholtz Distillery, 
Inc., 188 

27. Be ale Company, 199 

28. The Bayard Nail Company, 206 

29. Waters & Son, Inc., 227 

30. Shipstead Electronics Cor- 
poration, 236 

31. The Pan American Company, 
241 

32. International Trading and In- 
vestment Corporation, 245 

33. Miller Salt Company, 256 

34. Textron Inc. (A), 273 

35. Textron Inc. (B), 286 

36. The Reece Corporation, 291 

37. Textron Inc. (C), 295 

38. Textron Inc. (D), 299 

39. Trans World Airlines, 302 

40. Francono Cosmetics Company, 
310 

41. Textron Inc. (E), 317 

42. Textron Inc. (F), 323 

43. Continental Minerals Com- 
pany, 326 



429 



430 



Topical Index 



44. Russey Electrical Service 
Company, 330 

45. The Boston Patriots, 334 

46. Adamian Metallurgical Cor- 
poration, 351 



47. Microflex, Inc., 363 

48. Bill French, Accountant, 382 

49. Redwood Memorial Park, 389 

50. Harvard Law Review, 408 



(The numbers below refer to Case numbers. The Cases may be located by referring 

to the preceding list.) 



Accelerated depreciation, 29 
Acquisitions and mergers, 31, 32, 33, 34, 

35 
Administrative costs, deferral and amor- 
tization, 25 
Advertising expenditures, 6, 39, 40 
Allowance for bad debts, 3, 6, 17, 49 
Amortization: 

of deferred expenses (See Deferred 

expenses ) 
of expenditures for repairs, 43 
of intangible assets (See Intangible 
assets ) 
Application of funds statements, prepa- 
ration of, 9, 10, 11 
Appraisal of fixed assets, 4, 5, 6, 33, 35 
Appraisal procedures, in property valua- 
tion, 33 



B 



Bad debts, 3, 6, 17, 49 
Bond discount, deferral and amortiza- 
tion, 38 
Break-even chart analysis, 48 
By-product costing, 23, 24, 50 



Capital stock, issued in payment for 
patent, 23 

Carry-overs, of income tax operating 
losses, 34, 37 

Cash flow, as basis for valuation of a 
going concern, 33 

Chart of accounts, determination of, 47 

Classification of current and fixed as- 
sets, 26 

Classification of fixed and variable costs, 
48, 50 

Common stock, sold at discount from 
market, 38 

Common stock warrants, 38 



Comparative financial statements, analy- 
sis of, 12, 13, 14, 15 
Conservatism, value of, 32, 37 
Consistency of accounting policies, for 

diversified operations, 34, 37 
Consolidation of subsidiaries' operations, 

32, 34 
Contingent liability, under personal serv- 
ice contracts, 45 
Contingent payments, in acquisition of 

a subsidiary, 35 
Contingency reserves: 

for product warranties, 44 
under a self-insurance plan, 42 
Contracts, recognition of revenue on, 
construction contracts, 18 
installment sale contracts, 19 
service contracts, 1 
Correction of prior year's earnings, 1, 

28, 40 
Cost of goods manufactured, determina- 
tion of, 3, 12 
Cost of goods sold, determination of: 
for farming company, 24 
for industrial heat-treating company, 

46 
for land developers, 25, 49 
for manufacturing companies, 5, 23, 

26, 27, 28, 47, 48 
for movie producer, 21 
for trading companies, 20, 22 
Cost-price-volume relationships, 48 
Coupons outstanding, liability for, 7 
Current assets, classification of, 26 



Debentures, redeemed prior to maturity, 

38 
Debt, lease obligations equivalent to, 41 
Deferred expenses: 

administrative costs, 25 

bond discount, 38 

bonuses to football players, 45 

organization expenses, 2, 4, 23, 45 



Topical Index 

Deferred expenses (Cont.): 

promotion costs, 16, 21, 39, 40, 45 
research and development costs, 37 
training costs, 39, 45 

Deferred income taxes, 16, 19, 29, 34, 
37, 39, 42, 43 

Deferred revenue, 1, 16 

Departmental operations: 

analysis of results, 7, 8, 12, 50 
preparation of statements reflecting, 
2, 4, 6, 20, 44, 49, 50 

Depletion of mineral deposits, 33 

Depreciation: 

accelerated vs. straight-line, 29 
determination of asset life, 30, 33, 45 
group classification of assets, 30 
of land improvements, 24, 33 
reflecting changes in price levels, 36 
related to maintenance expenditures, 
29, 30 

Direct costing, 27 

Direct labor, classification of payroll 
costs as, 47 

Disclosure of lease obligations, 41 

Discount on bonds, 38 

Discounting technique, to reduce lease 
obligations to equivalent debt, 41 



Economic lot size determination, 50 

Economic vs. legal entity, in prepara- 
tion of statements, 49 

Entity concept, in preparation of state- 
ments, 49 

Estimated future revenue, as intangible 
asset, 16, 49 



F 



Financial statements, prepared for: 
determination of profit-sharing pay- 
ment, 20, 24, 29 
evaluation of employee's perform- 
ance, 22 
internal management use, 6, 16, 27, 

28, 29, 43 
prospective investors, 40, 45 
submission to bonding companies, 18 
submission to creditors, 5, 25, 26, 28, 

39, 49 
submission to stockholders, 7, 8, 16, 
19, 25, 32, 33, 43, 44 
Fire losses, accounting for, 6 
Fiscal year selection, 1, 8, 45 
Fixed assets: 

capitalization vs. expense, 6, 21, 45 
football players deferred as, 45 
valuation by appraisal, 4, 5, 6, 33, 35 



431 

Footnotes, to disclose lease obligations, 

41 
Franchises, 4, 20, 45, 49 
Funds flow statements, preparation of, 

9, 10, 11, 12, 14 



Going concern concept, in asset valua- 
tion, 32, 33 
Good will, 4, 20, 31, 32, 33, 35 

I 

Income tax regulations: 

allocation of purchase price in an ac- 
quisition, 33 
amortization of goodwill, 32 
amortization of organization expenses, 

45 
cost apportionment in a land develop- 
ment, 25 
deferral of research and experimental 

costs, 37 
depletion of mineral deposits, 33 
depreciation of tangible fixed assets, 

29 
operating loss carry-forwards and 

carry-backs, 34 
recognition of losses on property dis- 
posals, 34 
recognition of profit on construction 

contracts, 18 
tax payment dates, 8 
Incomplete data: 

analysis of financial statements from, 

12, 14, 15 
preparation of financial statements 
from, 1, 3, 4 
Inflation, effects of: 

on financial position, 36 
on pricing decisions, 30 
on reported earnings, 36 
Installment sales: 

analysis of cash flow, 11 
recognition of gross profit, 19 
Insurance cost and liability, for self- 
insurer, 42 
Intangible assets : 

estimated future revenue, 16, 49 
franchises, 4, 20, 45, 49 
goodwill, 31, 32, 33, 35 
mailing lists, 16, 40 
patents, 23 

personal service contracts, 32, 45 
prepaid federal income taxes, 37 
tax loss carry-forwards, 34 
Interest expense: 

added to value of aging whiskey, 26 
included in cost of goods sold, 41 



432 



Topical Index 



Interest income, imputed from sales, 49 
Inventory control, 28, 50 
Inventory valuation: 

of damaged goods, 3 

of finished manufactured goods, 12, 
26, 27, 28 

FIFO vs. LIFO, 23, 28, 35 

of growing crops, 24 

of joint products and by-products, 
23, 50 

of land developed for sale, 25, 49 

at lower of cost or market, 13 

of movies, 21 

retail inventory method, 22 

of used automobiles, 4, 20 

of used containers, 5 

of work-in-process, 13, 28 



Joint product costing, 23, 50 
L 

Land development costs, capitalization 
vs. expense, 24, 25, 49 

Lease obligations, 41 

Liabilities, indeterminate: 
for coupons outstanding, 7 
under incompleted contracts, 1 
for purchase price contingent on fu- 
ture earnings, 35 
for script outstanding, 40 
under a self-insurance plan, 42 
under warranty agreements, 44 

M 

Mailing lists, as an intangible asset, 16, 

40 
Monthly statements, prepared without 

closing books, 28 



N 



Natural business year, 1, 8, 45 

New business, preparation of financial 

statements for, 2, 3, 4, 6, 20, 23, 

25, 45 
Non-profit organizations, accounting for, 

7, 49, 50 



Objectives of a non-profit business, 50 
Operating cycle : 

for a sugar plantation, 24 

for a whiskey distiller, 26 
Organizational expenses, 2, 4, 23, 45 



Overhead allocation: 

between production departments, 24, 

28, 46, 47, 48, 49, 50 
to service departments, 28 
Overhead costs: 
effect on pricing decisions, 27, 46, 47, 

50 
in inventory valuation, 21, 24, 25, 26, 
27, 49, 50 
Overhead variance analysis, 27, 48 



Paid-in surplus, redetermined at date of 
merger, 34 

Partnerships, accounting for, 1, 4 

Patents, 23 

Percentage-of-completion method: 
of estimating cost of sales, 49 
of recognizing revenue, 18, 21, 25 

Personal service contracts, recorded on 
financial statements, 32, 45 

Pooling of interests, 32, 34 

Prepaid federal income taxes, 37 

Price-level changes, effect on deprecia- 
tion policy, 30, 36 

Price-volume-cost relationships, 48 

Pricing decisions, 27, 43, 46, 47, 50 

Product mix, effect on break-even point, 
48 

Production control, of manufacturing 
operations, 28 

Promotion costs, deferral and amortiza- 
tion, 16, 21, 39, 40, 45 



Ratio analysis of financial statements, 8, 

12, 13 
Recognition of profits of nonconsolidated 

subsidiaries, 32 
Recognition of revenue: 

from factoring commissions, 17 
on incompleted contracts, 1, 18, 19 
on intra-company sales, 25 
on magazine subscriptions, 16 
unclaimed deposits on containers, 5 
Repairs, extraordinary, 6, 43 
Research and development costs, defer- 
ral and amortization, 37 
Reserve for depreciation, overstated by 

group provision, 30 
Reserve for losses: 

on disposal of fixed assets, 34 
under self-insurance plan, 42 
Reserve for maintenance, 43 
Reserve for warranty claims, 44 
Retail inventory method, 22 
Revenue, recognition of (See Recogni- 
tion of revenue) 



Topical Index 



433 



U 



Sales cancellations, effect on profit, 49 
Script outstanding, liability for, 40 
Self-insurance liability reserve, 4% 
Standard costs, determination of, 28 
Storage costs, added to value of aging 

whiskey, 26 
Sum-of-years-digits depreciation, 29 



Unamortized discount, upon redemption 
of bonds, 38 



Valuation of assets acquired by acquisi- 
tion or merger, 4, 5, 6, 31, 32, 
33, 34, 35 

Volume-price-cost relationships, 48 



Tax loss carry-forwards, as an asset, 34, 
37 

Training costs, deferral and amortiza- 
tion, 39, 45 



W 



Warrants, for purchase of common stock, 

38 
Warranty liabilities, 44 




*/^t . , Date Due JM 2 6 '«2 
HOLIAL SCIENCES ROOM 
Due Returned Due Returned 












































































































, 








































































































BUSINESS 

ADM. 



Cases in accounting policy main 
658.15H283c 



3 15b5 03E^fl ima